Financial Stability Report July 2006 | Issue No.20

Financial Stability Report July 2006 1

BANK OF ENGLAND Financial Stability Report July 2006 | Issue No. 20

The Bank of England has two core purposes — monetary stability and financial stability. The two are connected because serious disruption in the financial system would affect the implementation and effectiveness of monetary policy, while macroeconomic stability helps reduce risks to financial stability.

The Bank’s responsibilities for monetary stability are set out in the Bank of England Act 1998. Responsibility for financial stability in the United Kingdom is shared between the tripartite authorities — HM Treasury, the Financial Services Authority (FSA) and the Bank of England. Their roles are set out in a Memorandum of Understanding (MoU).(1)

The Bank’s responsibility for contributing to the maintenance of the stability of the financial system as a whole derives from its responsibility for setting and implementing monetary policy, its role in respect of payment systems in the United Kingdom and its operational role as banker to the banking system. The Bank aims to bring its expertise in economic analysis and its experience as a participant in financial markets to the assessment and mitigation of risks to the UK financial system including, if necessary, helping to manage and resolve financial crises.

The Financial Stability Report aims to identify the major downside risks to the UK financial system and thereby help financial firms, authorities overseas and the wider public in managing and preparing for these risks. The Report is produced half-yearly by Bank staff under the guidance of the Bank’s Financial Stability Board, whose best collective judgement it represents.

The Financial Stability Board: Sir John Gieve, Chair Andrew Bailey Charles Bean Alastair Clark Nigel Jenkinson Mervyn King Rachel Lomax Paul Tucker

The Financial Stability Report is available in PDF at www.bankofengland.co.uk.

(1) The tripartite Memorandum of Understanding was revised in March 2006 and is available at www.bankofengland.co.uk/financialstability/mou.pdf.

Financial Stability Report July 2006 3

Contents

Foreword 1

Overview 5

1 Shocks to the UK financial system 14

Box 1 The fall and rise in major government bond yields 20 Box 2 Collateralised debt obligations and risk 21

2 Structure of the UK financial system 24

Box 3 Trading revenues and Value-at-Risk 27 Box 4 Leverage 32 Box 5 Financial market amplifiers 33

3 Prospects for the UK financial system 36

Box 6 Systemic stress testing 45 Box 7 Risk transmission in the Russian and LTCM crises 50

4 Mitigating risks to the UK financial system 51

Box 8 Risk assessment and crisis management 58

Other financial stability publications 62

Index of charts and tables 64

Glossary and other information 66

Overview 5

Overview

The Bank has made a number of changes since the December 2005 FSR, with the aim of providing a clearer, forward-looking synthesis of the key risks to the UK financial system. This is reflected in renaming this publication the Financial Stability Report. Section 1 of the Report assesses how macroeconomic and financial developments over the past six months have affected risks to the UK financial system, while Section 2 reviews changes in the structure of the system over this period. Section 3 provides the Bank’s assessment of key vulnerabilities in the light of those developments. Finally, Section 4 links this risk assessment to the mitigating actions that might be undertaken.

Risk-taking behaviour has swung markedly during the past six months. The early months of the year saw an intensification of risk taking and a corresponding rise in asset prices globally. Since May, risk appetites appear to have diminished somewhat and some asset prices have retraced their path. The profitability of the UK financial system remains high, helping to underpin its resilience to future disturbances. But the risks associated with the key vulnerabilities, while remote, have increased somewhat and remain significant.

What are the main vulnerabilities?

The Bank focuses on the resilience of the UK financial system as a whole, concentrating on the major UK banks, markets and infrastructures — not because that is where problems are most likely, but because an incident elsewhere is unlikely to have a system-wide impact in the United Kingdom unless it affects them. 6 Financial Stability Report July 2006

Financial markets are inherently volatile and there are always winners and losers within the financial system. But the UK financial system as a whole has been remarkably resilient over recent years in the face of a number of disturbances, including oil and commodity price shocks and, most recently, sharp falls in the prices of some risky assets. Several structural developments have helped to strengthen the system over time, including high profits and capital, continuing improvements in risk management and more sophisticated ways of distributing risk.

The Bank’s responsibility is not just to consider the most likely outcome but also to assess major downside risks. By their nature, these risks are likely to be low probability events in the tail of the distribution of possible outcomes. The fact that these risks are unlikely does not mean, however, they should be ignored. The Bank works collaboratively with HM Treasury (HMT) and the Financial Services Authority (FSA) to reduce the probability and impact of these remote risks and to prepare contingency plans for handling them should they crystallise.

The Monetary Policy Committee’s (MPC) projections for the UK economy are set out in the May Inflation Report. They show steady growth close to trend and inflation around the 2% target. This Report, while entirely consistent with that outlook, does not focus on forecasts of the most probable outcome for the financial system. Rather, it identifies underlying vulnerabilities that could, in improbable but plausible circumstances, generate risks to the UK financial system.

In considering these risks, it is helpful to distinguish the underlying sources of vulnerability within the system and the particular events that might trigger them. There are many events that are possible triggers, including avian flu, further oil price rises and heightened geopolitical risk. Whether they would in fact cause a problem for the UK financial system depends on its underlying health and structure.

In this Report, six main sources of vulnerability are explored. None of them is new and most are long standing. Although these vulnerabilities are unlikely to crystallise, either individually or in combination, the consequences for the UK financial system if they did could be material.

Their characteristics differ. Some arise from potential mismatches or mispricing in international financial markets. Others are rooted in extended balance sheet positions in parts of the non-financial sector. Others still reflect structural dependencies within the UK financial system. They can be grouped under three headings: Overview 7

Vulnerabilities in international financial markets • The unusually low premia for bearing risk presently prevailing across a range of asset markets, notwithstanding recent market movements. In part, this may reflect improved fundamentals and more efficient markets over recent years. But if risk premia rose abruptly, asset prices would fall sharply.

• Large financial imbalances among the major economies have continued over the past six months. These may unwind in an orderly fashion; but there is a risk of disorderly unwinding, which could conceivably crystallise credit and market risks.

Extended non-financial sector balance sheets • Rapid releveraging in parts of the corporate sector globally — for example, among commercial property companies or arising as a result of leveraged buyouts. Against a background of possibly underpriced corporate credit risk, this releveraging could widen and deepen over time.

• High UK household sector indebtedness in relation to income. Household balance sheets look strong in aggregate, but there are signs of stress among a minority of households, with personal insolvencies rising sharply.

Structural dependencies within the financial system • Rising systemic importance of large complex financial institutions (LCFIs) given their pivotal position in global capital markets and increasing links with UK banks. Their balance sheets and risk-taking activities also appear to be expanding.

• Dependence of UK financial institutions on market infrastructures and utilities for clearing and settling payments and financial transactions, whose contingency plans in the event of any disruption to their services may be inadequately understood and tested by some users.

The following sections of the Report assess news over the period relating to these areas of vulnerability (Sections 1 and 2), the scale of risk to the UK financial system (Section 3), and how those risks might be mitigated (Section 4).

How have the vulnerabilities changed?

The financial environment over the past six months has swung significantly. The early months of the year were characterised by increased risk taking and a further fall in the price of risk; the latter months by some scaling back of risk taking and a retreat in some asset prices. Even so, most asset prices remain a little higher than in December, though uncertainties around them are also greater. 8 Financial Stability Report July 2006

Chart 1 UK banks’ write-offs remain low(a)(b)(c) Low macroeconomic risk helps boost asset prices… During the early months of this year, the macroeconomic Mortgage Total household(d) Credit card Corporate environment, in the United Kingdom and globally, remained Other unsecured Per cent 5.5 benign. Against that backdrop, the balance sheets of UK 5.0 households and companies did not look especially stretched in 4.5 aggregate. This contributed to historically low realised credit 4.0 losses on UK banks’ household and corporate exposures. 3.5 Although write-off rates on unsecured loans to households 3.0 have increased sharply, aggregate write-off rates on household 2.5 and corporate loans are little different from a year ago 2.0 (Chart 1). 1.5

1.0 This benign picture was mirrored in rising global asset prices 0.5 during much of the first quarter — a continuation of the ascent 0.0

1999 2000 01 02 03 04 05 06 which began in 2002 (Charts 2 and 3) — along the entire risk spectrum. Some investors, such as hedge funds, continued Source: Bank of England. their search for yield. The LCFIs, as key risk intermediaries, (a) Data exclude Nationwide. (b) Write-off rates are dependent on specific bank policies, which may vary over time. continued to create opportunities to meet this demand. And, (c) Write-off rates on lending to UK residents. (d) ‘Total household’ is the sum of mortgage, credit card and other unsecured. at the same time, some institutional investors pursued a search for safe assets, sometimes to help hedge their Chart 2 Ascent of asset prices long-term liabilities. That contributed to further rises in the Index: Jan. 1998 = 100 price of both safe and risky assets. Implied volatilities of, and 300 correlations between, asset prices remained at low levels UK house price index 250 towards the end of the first quarter. UK commercial property index

200 …and affects the balance of risk-taking incentives at

Commodity (metals) financial firms… MSCI world equity price index 150 index With realised credit and market risk remaining low up until the end of the first quarter, and with liquidity buoyant, the profits 100 of financial firms, in the United Kingdom and globally, rose in

MSCI emerging markets most cases above earlier market expectations. Annual returns 50 equity index on equity for 2005 and 2006 Q1 came in around, or sometimes significantly above, 20% (Chart 4). 0 1998 99 2000 01 02 03 04 05 06 Sources: Bloomberg, Halifax, Nationwide and Thomson Financial Datastream. These developments appear to have tilted attitudes to risk. Many may have believed that the price of certain assets had become too high and the premium for taking risk too low. But there are business risks associated with acting on that view Chart 3 Descent of risk spreads(a) when others are not; it may not only reduce profitability in Spread basis points Spread basis points 200 1,000 the short run, but may also risk losing market share or failing (b) 175 High-yield corporations 875 to establish a foothold in a rapidly expanding market. These (right-hand scale) concerns often seem to have outweighed the risks to balance 150 750 sheets associated with potentially overpriced assets. As a Emerging markets 125 (right-hand scale) 625 result, in the early part of this year, there appears to have been an extension of risk-taking activities by financial institutions, 100 500 including some UK banks. 75 375

50 250 Against that background, the balance sheets of UK banks and Investment-grade corporations UK-operating LCFIs continued to expand rapidly (Chart 5). In (left-hand scale) 25 125 part, this appears to have reflected position-taking in risky and 0 0 2002 03 04 05 06 prospectively illiquid instruments including structured credit

Sources: Bloomberg, JPMorgan Chase & Co. and Merrill Lynch. products, emerging market assets, commodities and

(a) Asset swap spreads. commercial property. Financial engineering resulted in a (b) December 2005 FSR. further wave of complex leveraged instruments being created. And the market in leveraged buyouts remained buoyant. Overview 9

Chart 4 Return on common equity — high and rising With market liquidity high, the ex-post risk-adjusted return on these instruments remained high and correlations between US securities houses European LCFIs(a) US commercial banks Major UK banks(a)(b) Per cent returns low. So portfolios appeared both high-yielding and 25 well-diversified. For UK banks, the financing of these positions appears to have been met increasingly from wholesale funding 20 markets.

15 …but perceived risks have risen more recently, with a knock-on to asset prices. 10 More recently, there have been signs of a more cautious pattern of behaviour. Uncertainties about the direction of the 5 macroeconomic environment — both inflation and growth — and macroeconomic policy have increased in some of the 0 major economies. Perhaps in consequence, even relatively Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 2003 04 05 06 modest pieces of macroeconomic news appear to have had a

Source: Bloomberg. significant effect on financial markets.

(a) Data for European LCFIs and major UK banks are half yearly. (b) Data for the major UK banks exclude building societies. The initial effects of the tightening of monetary conditions across the G3 during the first quarter, and the turnaround in Chart 5 Balance sheets expand rapidly global long-term bond yields at around the same time, were US securities houses US commercial banks muted. Starting in May, however, there has been a sharp and European LCFIs Major UK banks(a) Index: end-2000 = 100 persistent adjustment in the prices of some risky assets, 240 especially those asset classes whose price had risen fastest earlier in the year — equities, commodities and emerging 200 market assets (Chart 6). Implied volatilities of, and correlations between, assets have risen from their abnormally 160 low levels (Chart 7).

120 In most respects, this has been a healthy correction. While 80 daily price adjustments have been large, market conditions have remained orderly. Although significantly lower than at 40 the start of May, the level of many asset prices is little different from at the start of the year (Table A). And although 0 2001 02 03 04 05 higher, volatilities and correlations remain below their levels Source: Bloomberg. during previous periods of market turbulence (Chart 7). (a) Due to changes introduced under IFRS, figures for 2004 and 2005 use the most comparable Market intelligence suggests there has been some paring back data possible. of risk-taking activities as higher volatility has persisted. But Chart 6 Asset prices adjust the central view of market participants remains that this is a Index: 4 Jan. 2005 = 100 230 limited correction in the price of risk and these developments have not, at least as yet, resulted in a fundamental rethink of Commodity (metals) price index 210 medium-term risk strategies by investors or financial (a) 190 intermediaries.

170 The key vulnerabilities have worsened slightly…

150 Table B provides a summary of how this news over the past six months has affected the Bank’s judgement on the six sources MSCI emerging markets FTSE 100 130 of vulnerability discussed in this Report. It is broken down into index news about the likelihood of them occurring (probability) and 110 MSCI world equity index the consequences for the UK financial system if they were to 90 do so (impact). Jan. Mar. May July Sep. Nov. Jan. Mar. May 2005 06

Sources: Bloomberg, Thomson Financial Datastream and Bank calculations. None of the vulnerabilities has altered markedly in terms of

(a) December 2005 FSR. probability or impact over the past six months. Perhaps the most significant news relates to low risk premia within 10 Financial Stability Report July 2006

Chart 7 Implied equity market volatility(a) rises financial markets. But with the price of risk having first fallen and then risen, the net effect on the probability of this Per cent 50 vulnerability crystallising has been broadly neutral. The impact FTSE 100 45 of such an event has increased over the period, however, as risk 40 exposures appear to have further accumulated across the UK

35 financial system. S&P 500 30

25 Corporate credit risks have increased further as releveraging

20 has continued in some parts of the sector, at the same time as the price of corporate credit has remained low. The potential 15 impact of stress on LCFIs’ balance sheets has increased slightly, 10 in line with their stronger links to the UK banking system. The 5 likelihood of household vulnerabilities crystallising has nudged 0 1990 92 94 96 98 2000 02 04 06 up too, as personal insolvencies have risen sharply. On

Sources: Bloomberg, CME, Euronext.liffe and Bank calculations. balance, the risks to UK financial stability from global

(a) Three-month (constant maturity) implied volatilities. imbalances and from the possibility of a disruption to market infrastructure are little changed over the past six months.

…but individually appear manageable for UK banks. Gauging the potential severity of each of these vulnerabilities, rather than how they have changed, is more problematic. As a Table A Risky asset prices rise then fall contribution towards making those judgements, Bank staff have considered some hypothetical stress scenarios for each of October Peak in Changes the vulnerabilities and have estimated their potential impact 2002 to 2006 to since peak(a) 26 June Dec. on the UK banking system. The uncertainties around these in 2006 2006 2005 FSR model-based impact estimates are considerable, for this stress-testing approach is better at capturing some types of MSCI world equity index(b) +84 –10 +3 risk (such as credit risk) than others (such as liquidity risk). MSCI emerging markets equity index(b) +216 –21 +4 Industrial metals price index(b) +258 –19 +39 This initial calibration also makes some strong assumptions Investment-grade bond spreads(c) –113 +5 –2 about the behaviour of financial firms — for example, that they Sub-investment grade bond spreads(c) –535 +32 –29 do not adjust their balance sheets following disturbances. (c) Emerging market bond spreads –545 +52 –7 Nonetheless, these estimates can be used as a starting point Sources: Bloomberg, Goldman Sachs, JPMorgan Chase & Co., Merrill Lynch, Thomson Financial Datastream and when assessing the prospective scale of each of the main Bank calculations. vulnerabilities under conditions of stress. (a) The peak date is the 11 May 2006 for all series, except for the emerging markets bond index, emerging markets equity index and the world equity index for which 3, 8 and 9 May 2006 are used respectively. (b) Per cent. (c) Basis points. As Section 3 describes, while the estimates are preliminary, it is clear that the scale of losses associated with the six vulnerabilities under these hypothetical stress scenarios could be significant. For some of the vulnerabilities, the losses in an extreme scenario could come close to absorbing the annual profits of the major UK banks. While losses on this scale would Table B Some key vulnerabilities edge up be unlikely to disrupt materially the functioning of the UK A significant increase in risk Broadly unchanged financial system as a whole, they could in extreme A slight increase in risk A slight decrease in risk A significant decrease in risk circumstances affect the reputation and financial standing of

VulnerabilityProbability(a) Impact(b) some UK institutions.

Low risk premia Global imbalances What lies ahead? Global corporate debt UK household debt LCFI stress Continuing resilience — though future risk-taking behaviour Infrastructure disruption remains uncertain. Source: Bank calculations. All of the stress scenarios considered are low probability tail (a) Assessed change in the probability of a vulnerability being triggered over the next events. Far and away the most likely outcome in the near term three years. (b) Assessed change in the expected impact on major UK banks’ balance sheets if a vulnerability is that none of the vulnerabilities crystallise. Moreover, even if is triggered. these vulnerabilities were to crystallise individually, they would Overview 11

Chart 8 Major UK banks’ default premia remain low be unlikely to erode to any significant extent the capital base of the UK banking system. This provides strong support for the Maximum-minimum range (a) continuing high resilience of the UK financial system. Market Average Basis points 55 estimates of default probabilities for the major UK banks — as (b) 50 proxied by CDS premia — remain very low and are consistent 45 with that encouraging picture (Chart 8). 40 35 The evolution of risk within the system in the period ahead will 30 depend on the future behaviour of financial firms and 25 investors. Recent market volatility has reminded investors and 20 firms of the financial risks they are running. But it remains an 15 open question whether it has changed decisively the perceived 10 balance between financial and business risks. On the one 5 hand, there is some evidence of greater caution about 0 2002 03 04 05 06 position-taking among some market participants, as the price Sources: Bloomberg, Markit and Bank calculations. of risk has risen over the past two months. On the other, the (a) Average CDS premia weighted by total assets. prices of risky assets are little changed from six months ago. (b) December 2005 FSR. Previous recent short-lived episodes of turbulence have, if anything, tended to reinforce perceptions about the stability of the system and have encouraged a return to the risk-seeking environment seen earlier. It is too early to assess whether that pattern will be repeated this time.

Vulnerabilities in combination… When gauging the future resilience of the UK financial system, it is important also to consider what would happen if several vulnerabilities crystallised in combination. The Report discusses two extreme but plausible scenarios:

• A sharp turn in the credit cycle: There are several potential supply-side factors (for example, a marked further rise in oil and other commodity prices) which might prompt such a reassessment of creditworthiness. Were the credit cycle to turn sharply due to these forces — for example, on the scale of the early 1990s recession in the United Kingdom — it would have implications for, in particular, the corporate and household vulnerabilities.

• A substantial further fall in asset prices: Despite recent market movements, an abrupt and widespread rise in risk premia and risk-free rates would have important implications for, in particular, the low risk premia, global imbalance, household and corporate vulnerabilities.

…could trigger additional amplification channels… In such severe stress situations, certain structural features of the UK and global financial systems, which have grown in importance over the past few years, could amplify market and credit risks. For example, UK and international institutions have increased their exposures to potentially illiquid instruments over recent years. Given their potential illiquidity, a rapid unwind of these positions in the event of losses would tend to depress prices by more than has been the case in the past, particularly if many investors were pursuing similar 12 Financial Stability Report July 2006

strategies in such markets. The adjustment in the prices of some risky assets during May and June illustrate these effects.

On the liabilities side of the balance sheet, UK banks’ increasing dependence on wholesale funding has heightened their sensitivity to liquidity developments. Increasing linkages within the UK financial system — for example, arising from interbank and counterparty exposures between UK banks and LCFIs — would also amplify the transmission of risk at a system-wide level. All of these factors would tend to increase correlations between asset returns in a stress scenario, thereby reducing some of the diversification benefits that appeared to exist when correlations were low. Again, recent market developments perhaps illustrate such effects, albeit on a limited scale.

…highlighting the need for consideration in firms’ risk management. The severe crystallisation of credit, market and liquidity risk could plainly represent a serious shock to the UK financial system. Such extreme scenarios could be sufficient to more than absorb the annual profits of the UK banking system and therefore cause some material erosion of capital. Although such an outcome is very unlikely, given its potential impact, it merits consideration in financial firms’ risk management planning.

What actions are needed?

A range of actions might usefully be taken by both the private and official sectors to insure against these risks. These actions would include:

• Improved risk measurement and management: There have been significant advances in private sector stress testing over recent years and this is high on the FSA’s agenda too. Rather less progress has been made, however, in gauging the combined effects of market, credit and liquidity risks that might materialise in an extreme tail event. Further work is needed on that front. A second priority area is ensuring that extreme, but plausible, macroeconomic stress scenarios inform firms’ risk decisions. Macroeconomic stability may have made such stress tests seem less necessary. The public authorities can help ensure that they are carried out and appropriately acted on by firms’ management. Publishing the results of these stress tests would further enhance market discipline. A third priority area is liquidity risk management, in particular liquidity risks arising in markets for new and complex instruments. More work is needed on appropriate liquidity standards for firms and liquidity stress tests, both domestically and internationally. Overview 13

• Improved system-wide stress testing: Most firm-level stress testing treats the behaviour of other system participants as fixed. Rising system interconnections, both direct exposures and indirect market linkages, including through complex structured products, make this assumption increasingly unrealistic. Identifying, understanding and calibrating the impact of these interconnections on risks to the system is a priority. This will require further work by both the private sector and the authorities.

• Improved crisis management capability: If the potential systemic impact of vulnerabilities is increasing, effective management of such events should they crystallise is an even greater priority. There is a considerable work programme under way, in the United Kingdom and internationally, to improve procedures and information for helping deal with financial or business continuity problems. But further analysis and testing work is needed to develop contingency plans in the event of stress to a major market infrastructure or an LCFI — for example, to ensure effective communication between the private and public sectors and between international authorities. 14 Financial Stability Report July 2006

1 Shocks to the UK financial system

Global growth prospects appeared to firm early in the year and asset prices rose further, reflecting a continued search for yield by some investors. Global monetary conditions were tightened and yield curves shifted upwards. As the year has progressed, perceived uncertainty about the global macroeconomic outlook has Chart 1.1 Real GDP growth forecasts, 2006 and risen and financial market volatility has 2007(a)(b)(c)

Per cent increased. Asset price corrections during May 4.0 (d) and June do not appear to reflect a fundamental

United States 3.5 change in risk preferences, but may be a signal of heightened market sensitivity in the period 3.0 ahead. In aggregate, UK household and United Kingdom 2.5 corporate balance sheets continue to look

Euro area 2.0 healthy.

Japan 1.5 This section discusses developments in the macroeconomy and in global financial markets over the past six months that 1.0 0.0 Jan. Apr. July Oct. Jan. Apr. have affected risks to the UK financial system. 2005 06

Source: Consensus Economics Inc. Uncertainty about the macroeconomic outlook increases…

(a) Solid lines are 2006, broken lines are 2007. The global economic outlook appeared to strengthen in the (b) Average annual percentage changes. (c) Horizontal axis refers to the month the survey was taken. first quarter of 2006 (Chart 1.1). Steady growth was forecast (d) December 2005 FSR. for 2006 in the United Kingdom and the United States, while expectations for growth rose modestly in the euro area and Chart 1.2 Distribution of US GDP growth and inflation strongly in Japan. Solid growth in all economies was expected forecasts for 2007(a) for 2007. But as 2006 has developed, signs of capacity Density (per cent) Density (per cent) constraints in the United States and rising commodity prices 5 9 have raised concerns over prospects for inflation. Uncertainty June 2006 8 surrounding the medium-term macroeconomic outlook has 4 June 2006 7 increased, particularly in the United States (Chart 1.2). 6 3 5 …and global monetary conditions tighten. Over the past six months, monetary conditions have tightened 4 2 in the major economies. The US Federal Open Market Jan. 2006 3 Committee raised its target rate by 25 basis points at each of 1 2 the five meetings since the December 2005 FSR. The European

Jan. 2006 1 Central Bank raised interest rates by 25 basis points on three

0 0 occasions. And in March, the Bank of Japan announced the end 2.3 2.5 2.8 3.0 3.3 3.5 0.8 1.3 1.8 2.3 2.9 3.4 GDP growth CPI of quantitative easing. The Bank of England’s Monetary Policy Committee kept rates unchanged over the period. Forward Sources: Consensus Economics Inc. and Bank calculations. interest rates suggest that market participants expect further (a) Densities constructed by fitting kernel functions to individual forecasts provided by Consensus Economics Inc. The area under an estimated density sums to 100%. increases in policy rates over the next few months (Chart 1.3). Section 1 Shocks to the UK financial system 15

(1) Chart 1.3 Official and forward interest rates(a) The transition to higher world interest rates may be bumpy. The effects of recent interest rate increases are not yet clear December 2005 FSR 29 June 2006 Per cent 6.0 and, together with heightened concerns about inflation and 5.5 growth, this has increased slightly uncertainty about the future

United Kingdom(b) 5.0 path of short-term interest rates. Implied volatilities of 4.5 short-term interest rates remain low by historical standards, 4.0 Euro area(c) but have edged up a little over the past two months 3.5 (Chart 1.4). Although the central view of market participants 3.0 United States(c) 2.5 remains that the benign macroeconomic environment will 2.0 continue, perceived risks around this view appear to have 1.5 increased. Japan(c) 1.0 0.5 Earlier in the year, the Bank’s market intelligence indicated that 0.0 some market participants may have been underestimating the 2003 04 05 06 07 08 uncertainty surrounding macroeconomic policy and Sources: Bloomberg and Bank of England. macroeconomic outcomes.(2) If perceived macroeconomic (a) Solid lines are official interest rates and dotted lines are forward interest rates. uncertainties increase, risk premia would be expected to rise (b) Forward rates based on Libor. Forward curves shown in the chart are fifteen-day averages of one-day forward rates. The curves have been adjusted for credit risk. and asset prices to fall. Financial market developments during (c) Forward rates based on dollar Libor, Euribor and yen Libor respectively. These curves have not been adjusted for credit risk. May and June illustrate this process (discussed below).

Chart 1.4 Implied interest rate volatility(a) Supply shocks could further disturb macroeconomic Basis points expectations… 180 Sterling Global supply shocks, which boost inflationary pressure but 160 Dollar constrain growth, could be one possible source of future 140 disturbance to macroeconomic expectations. These include a 120 sudden rise in geopolitical risk (such as rising tensions with

100 Iran), an avian flu pandemic or a further sharp rise in oil and commodity prices. The price of Brent crude has already risen 80 significantly. At the end of April, the price was more than 60 double the level at the end of 2003 and $18 per barrel higher 40 Euro than at the time of the December 2005 FSR. In real terms, this 20 was its highest level since 1982 (Chart 1.5). Rising oil prices appear to reflect a combination of strengthening world 0 1999 2000 01 02 03 04 05 06 demand and concerns about future supply, including Sources: Bloomberg and Bank calculations. disruptions to production in Nigeria and geopolitical tensions (a) Twelve-month (constant maturity) implied volatilities. in the Middle East. By end-June, oil prices had fallen by about $5 per barrel from their peak and are currently around $70 per Chart 1.5 Real prices of oil and selected metals(a) barrel. Prices of oil futures suggest that markets expect spot

Index: 1 July 1993 = 100 prices to remain above their December levels. 500 450 Non-energy commodity prices have also increased sharply. At 400 its peak in May, the Goldman Sachs industrial metals index 350 was 70% higher than at the time of the December 2005 FSR. 300 Gold, silver, and copper prices reached their highest real levels Silver 250 for around two decades (Chart 1.5). As with oil, fundamental

200 factors, such as strong demand for raw materials in emerging Copper(b) 150 economies, particularly China, appear to have pushed up prices. But speculative factors appear also to have been at Gold 100 work (Chart 1.6), facilitated by financial market innovations Oil(c) 50

0 1979 81 83 85 87 89 91 93 95 97 99 2001 03 05 (1) This was discussed in more detail in a speech by the Governor in Scotland on 12 June 2006, available at www.bankofengland.co.uk/publications/speeches/ Sources: Bloomberg, Global Financial Data, International Financial Statistics, Thomson Financial 2006/speech277.pdf. Datastream and Bank calculations. (2) These points were discussed in more detail in a speech by the Governor in Gateshead on (a) Nominal commodity prices deflated by US CPI. 11 October 2005, available at www.bankofengland.co.uk/publications/speeches/ (b) Monthly data until December 1988, daily data thereafter. 2005/speech256.pdf, and by Paul Tucker in Chicago on 25 May 2006, available at (c) Monthly data until June 1983, daily data thereafter. www.bankofengland.co.uk/publications/speeches/2006/speech274.pdf. 16 Financial Stability Report July 2006

Chart 1.6 Speculative positions in gold futures such as exchange-traded commodity funds, commodity indices and structured commodity products. In early May, the US$ per troy ounce Number of contracts, thousands 800 250 Chairman of the London Metal Exchange warned of a bubble developing in the market. Industrial metals prices have since 700 Price (left-hand scale) 200 fallen, by around 20% from their peak, but remain around 600 150 40% above December levels.

500 100 Net position (right-hand scale)(a) …and rising oil prices have widened global imbalances. 400 50 The rise in energy prices has contributed to the US current account deficit remaining high, at 6.4% of GDP in 2006 Q1. + 300 0 – Deficits in recent years have raised US net foreign liabilities to

200 50 around 20% of GDP, from a small net asset position 18 years ago. As the counterpart to this, oil exporters’ current account 100 100 surpluses have risen and are now similar in absolute size to 1997 98 99 2000 01 02 03 04 05 06 those in East Asia (Chart 1.7). As a result, the continued Sources: Bloomberg, Commodity Futures Trading Commission, Thomson Financial Datastream and Bank calculations. financing of the increasing US net liability position is heavily

(a) Difference between long and short non-commercial positions, ie positions unrelated to reliant on the portfolio choices of reserve managers in Asia and commercial hedging activities. a group of oil-exporting countries.

Chart 1.7 Global current account balances(a) Since the December 2005 FSR, macroeconomic adjustments United States Japan have taken place which could over time facilitate an orderly Oil exporters(b) Other EMEs(c) China Other advanced economies unwinding of global imbalances. The US dollar exchange rate US$ billions 1,000 index has fallen by around 5% and growth and short-term

800 forward interest rate differentials between Europe and Japan

600 and the United States have narrowed. To date, these

400 adjustments in asset prices and growth have been orderly. But with the US deficit remaining wide, there continues to be some 200 + risk of a dislocation in prices which might be amplified by 0 – certain structural features of financial markets (see Box 5 in 200 Section 2) or by further diversification by reserve managers out 400 of dollar assets. Section 3 considers the potential implications 600 for the UK financial system in the unlikely event of a disorderly 800 unwinding of global imbalances. 1,000 (d) 2003 04 05 06 Household insolvencies have increased sharply… Source: IMF. Aggregate household balance sheets in the United Kingdom are (a) Global current account balances do not sum to zero due to errors and omissions. (b) The sum of the ten largest oil exporters in 2004 — Algeria, Iran, Kuwait, Mexico, Nigeria, strong. Although personal indebtedness has increased rapidly, Norway, Russia, Saudi Arabia, United Arab Emirates and Venezuela. (c) Other EMEs includes the Newly Industrialised Asian economies. so too has the value of the stock of housing and financial (d) IMF forecast, April 2006. assets, with the result that net household wealth rose by 9% over the year to 2005 Q4. Years of house price increases have created cohorts of mortgage borrowers with houses valued at substantially more than their loans. The ratio of net household wealth to income has increased by 4% over the past year and is a third higher than its trough around ten years ago.

This benign overall picture masks areas of vulnerability, however.(1) House price rises have not benefited renters, who typically have lower and more volatile income. Lower income debtors are much more likely to have liabilities that exceed their assets (Chart 1.8) and are particularly exposed to rises in energy prices. Moreover, borrowing by such vulnerable households, including sub-prime mortgage borrowing, has

(1) For more analysis see Barwell, R, May, O and Pezzini, S (2006), ‘The distribution of assets, income and liabilities across UK households: results from the 2005 NMG Research survey’, Bank of England Quarterly Bulletin, Spring, pages 35–44. Section 1 Shocks to the UK financial system 17

Chart 1.8 Ratio of assets to liabilities of UK debtor grown rapidly in recent years. Rapid house price rises have households, September 2005(a) also increased loan to income ratios for first home buyers. Reflecting these developments, personal insolvency rates have Zero >0 and <1 increased sharply in the past few months (Chart 1.9). > = 1 Per cent of debtors in each income quintile 100 Excluding the self-employed, insolvency rates are three times higher than their early-1990s peak, though still only about a quarter of the recent average in the United States. 80

It is possible that there is a growing acceptance of insolvency 60 as a way for debtors to restructure their borrowings. As discussed in the May 2006 Inflation Report, the introduction of 40 a new bankruptcy regime may have increased the incentives for bankruptcy in England and Wales, though personal 20 insolvencies have also increased in Scotland and Northern Ireland where there has been no change in regime. Any

0 structural change in behaviour might be amplified if the <8.58.5–14.5 14.5–21.5 21.5–37.5 >37.5 Gross annual household income (£ thousands) macroeconomic environment were to change sharply. Section 3 considers the potential losses to the UK financial Sources: NMG Research survey and Bank calculations. system in the unlikely event of an increase in stress within the (a) Ratio computed for households with any debt who report information on assets, liabilities and income. A ratio of less than one indicates households with more liabilities than assets. UK household sector.

Chart 1.9 Annualised insolvency rates(a)(b) In the United States, where several UK banks also have a large Per cent Per cent 0.30 3.0 exposure to the household sector, the household saving ratio Corporate insolvency rate has been negative since 2005 Q2. Nevertheless, household (right-hand scale)(c) 0.25 2.5 net worth increased by 10% in the year to 2006 Q1, reflecting rapid equity and house price increases. House price inflation 0.20 2.0 has eased back more recently, with quarterly inflation falling by 1 percentage point in 2006 Q1 (to 2%). Rising house prices 0.15 1.5 have been accompanied by rising mortgage debt (up 15% over the year) and an increasing proportion of new mortgages are at 0.10 1.0 variable rates (around 30%). Both developments increase the US household sector’s sensitivity to future interest rate rises. 0.05 Personal insolvency rate 0.5 (left-hand scale)

0.00 0.0 …and the corporate credit cycle may also be turning… 1976 79 82 85 88 91 94 97 2000 03 06 In contrast to households, UK corporate insolvencies in Sources: DTI, ONS and Bank calculations. April 2006 remained close to their lowest level for 25 years (a) 2006 Q1 figures provisional from DTI. (Chart 1.9). As a result of strong profits and relatively modest (b) Figures for England and Wales only. (c) Ratio of annualised insolvencies in the quarter to active registered companies in the last investment expenditure, the UK corporate sector has been a month in that quarter. net saver and has accumulated large balances of liquid and Chart 1.10 PNFCs’(a) annualised net equity issuance financial assets. This unusual behaviour is also occurring in Percentage of GDP other countries. 6

United Kingdom 4 Companies in the United Kingdom and United States have been redeeming rather than issuing equity in recent years in

2 net terms (Chart 1.10) and net corporate debt issuance has + been low. These factors may have boosted equity valuations 0 of firms and lowered their cost of finance. At the same time, – there has been strong corporate borrowing from banks, in United States 2 particular by UK commercial property companies. Accompanying this, UK commercial property prices have 4 risen sharply, by 15% in the year to May 2006 (Chart 1.11). Taken together, however, corporate leverage ratios, measured 6 1990 92 94 96 98 2000 02 04 06 at market prices, have fallen further from their peaks in early Sources: Board of Governors of the Federal Reserve System, ONS and Bank of England. 2003 as firms have sought to repair their balance sheets (a) Private non-financial corporations. (Chart 1.12). 18 Financial Stability Report July 2006

Chart 1.11 Annual UK commercial property price This underlying balance sheet strength has encouraged a wave inflation(a) of leveraged buyouts (LBOs), often involving private equity firms. The rise in LBOs has been particularly strong in the Per cent 30 United States and Western Europe, but somewhat more 25 moderate in the United Kingdom (Chart 1.13). LBO purchase 20 prices have risen to record multiples of earnings and 15 competition between lenders has resulted in a continued

10 relaxation of loan covenants. Standard and Poor’s estimate

5 that the debt taken on by a typical European LBO rose to more + 0 than eight times earnings in 2005, up from seven times in – 2004. LBO borrowing, though, remains small relative to the 5 stock of UK corporate debt. Bank staff estimates suggest that, 10 because LBO-funded companies have historically had a higher 15 average probability of default, the direct impact of LBO 20 1980 84 88 92 96 2000 04 transactions in 2004 and 2005 may have been to increase the

Sources: Investment Property Databank, Thomson Financial Datastream and Bank calculations. average annual default probability of UK companies by about

(a) Interpolated values used prior to 1988. 0.2 percentage points.

Given current profitability, balance sheet strength and high equity valuations, the low level of corporate default in the Chart 1.12 PNFCs’(a) capital gearing(b) United Kingdom is perhaps unsurprising. But some of these Per cent 70 supportive trends may not persist. UK and US corporate

United States leverage ratios look less healthy on a replacement cost basis 60 (Chart 1.12). And, as discussed in the December 2005 FSR, 50 commercial property prices are higher than might be expected based on rental income and risk-free interest rates. 40 To date, LBOs have affected only a subset of firms. But

30 market contacts suggest the threat of buyouts and the relatively low cost of capital may be encouraging other 20 companies to re-leverage. If these patterns continued, they United Kingdom 10 would increase the vulnerability of global corporate balance sheets to a change in the future financial environment. For 0 1988 90 92 94 96 98 2000 02 04 06 example, rising input prices may squeeze future corporate profitability and the cost of capital could rise quickly if Sources: Board of Governors of the Federal Reserve System, ONS and Bank calculations. investor risk appetite fell. Reflecting these developments, (a) Private non-financial corporations. (b) Solid lines are gearing ratios at market value, dashed lines at replacement cost. credit rating agencies are anticipating a gradual turning of the corporate credit cycle, with the proportion of credit rating downgrades increasing relative to upgrades in the Chart 1.13 LBO loan issuance(a) United States, the United Kingdom and the rest of Europe

Rest of world United States over recent quarters. Section 3 considers in more detail the Rest of Western Europe United Kingdom US$ billions potential losses to UK banks in the unlikely event of a sharp 180 deterioration in corporate prospects. 160

140 …as a result of rising risk-free rates.

120 One possible source of rising borrowing costs for the household and corporate sectors is a rise in government bond 100 yields — also referred to as ‘safe’ or ‘risk-free’ interest rates. 80 Nominal government bond yields at a ten-year maturity have 60 risen by around 70 basis points in the United Kingdom from 40 their trough in January 2006. This has been a global

20 phenomenon, with risk-free rates rising in all major markets and across all maturities. 0 1986 88 90 92 94 96 98 2000 02 04 06

Source: Dealogic. To some extent, these yield curve shifts appear to reflect (a) Data are bi-annual, 2006 H1 includes data up to 26 June 2006. upward adjustments in inflation expectations and inflation risk Section 1 Shocks to the UK financial system 19

Chart 1.14 Market-implied US inflation expectations(a) premia, particularly over short-term horizons. For example, differences between yields on nominal and inflation-indexed Per cent 2.8 government bond yields in the United States suggest that implied inflation expectations have risen by more than 2.7 0.3 percentage points at a two-year horizon in recent months

26 June 2006 (Chart 1.14). But the greater part of the rise in nominal yields

2.6 reflects higher global real interest rates (Chart 1.15 and Box 1).

2.5 The effects on risky asset prices were initially modest... December 2005 FSR In principle, a rise in the risk-free rates used to discount risky

2.4 assets should generate a fall in the price of those assets. In practice, for the first part of the year, the prices of risky assets (1) 2.3 rose further as the search for yield appeared to intensify. 0.0 024681012 This was most noticeable in high-risk instruments, but affected Years ahead the entire risk spectrum to some degree. Source: Bank of England.

(a) Difference between nominal and inflation-indexed implied forward rates. Compensation for risk on the speculative, ‘equity’, tranches of Chart 1.15 Global real long-term interest rates(a)(b) collateralised debt obligations (CDOs) fell sharply until late April (Chart 1.16) — see Box 2 for details on the characteristics Per cent 4 of the pay-off structures for tranches of CDOs. At the same time, prices of other high risk assets, such as emerging market United States bonds and equities (Chart 1.17), speculative-grade corporate 3 bonds and commodities, were rising rapidly. Spreads on speculative-grade corporate bonds and emerging market Euro area foreign currency sovereign bonds each fell by around 60 basis 2 points between the December 2005 FSR and early May. By early May, emerging market spreads had fallen to similar levels 1 to investment-grade corporate bonds in late 2002. Emerging

United Kingdom market equity prices rose 30% between the December 2005 FSR and early May. 0 2003 04 05 06

Sources: Bank of England and Bloomberg. Prices of more moderate risk assets also rose in the early part

(a) Instantaneous forward rates. The US real interest rate is derived from government bonds which of the year, although by somewhat less. Spreads on are linked to the CPI. The euro-area real interest rate is derived from nominal government bond yields and CPI inflation swaps. The UK real interest rate is derived from government bonds ‘mezzanine’ tranche CDOs narrowed further. And, global linked to RPI. CPI and RPI-based measures of real interest rates are not strictly comparable, as the inflation rates are constructed differently. equity prices rose by 14% between the December 2005 FSR (b) Nine-year rate for the United States. Ten-year rate for the United Kingdom and the euro area. and early May. Low risk asset prices also rose. Spreads on senior CDO tranches continued their long decline and Chart 1.16 CDO tranche spreads and fees(a)(b) investment-grade bond spreads fell slightly. Spread (basis points) Upfront fee (per cent of notional) 350 70 0%–3% (right-hand scale) As risky asset prices were rising strongly, implied volatilities on 300 3%–7% (left-hand scale) 60 7%–10% (left-hand scale) a number of financial instruments, such as major equity 10%–15% (left-hand scale) 250 15%–30% (left-hand scale) 50 indices, remained low (Chart 1.18) and market liquidity remained strong. Correlations between asset price 200 40 movements also remained low, giving the impression of risk 150 30 having been well diversified (Chart 1.19).

100 20 …but more recently asset prices have started to correct… 50 10 Over recent months, there have occasionally been indications of an increasing edginess in financial markets. Often 0 0 Jan. Mar. May July Sep. Nov. Jan. Mar. May seemingly modest pieces of macroeconomic news had a 2005 06

Source: JPMorgan Chase & Co. (1) Low nominal interest rates may encourage some investors and financial institutions to (a) Losses incurred on the notional principal of the reference North America investment-grade intensify their demand for sources of higher investment returns by purchasing more CDS index are allocated from the most junior (0%–3%) tranche through to the more senior tranches as losses increase. risky assets. For some financial intermediaries, the ‘search for yield’ is motivated by (b) 0%–3% tranche often referred to as ‘equity’, 3%–7% as ‘mezzanine’ and others as grades of having a portion of their liabilities which carry minimum nominal return guarantees. senior tranches. See page 11 of the June 2003 FSR for more details. 20 Financial Stability Report July 2006

Box 1 the strength of corporate balance sheets across the major The fall and rise in major government bond economies, is that market participants are expecting increased future investment. A second hypothesis is that market yields participants have increased their expectations of the neutral rate required to deliver stable inflation in the longer run, Risk-free rates in major economies have moved significantly following recent monetary tightening.(2) since the December 2005 FSR. Ten-year government bond yields fell sharply in January, but have since rebounded by 70–80 basis points in the United States, the euro area and the Chart A International nominal forward rates(a)(b) United Kingdom. Long-term yields have moved little since the Per cent 6.0 middle of May, as some risky asset prices have fallen. US dollar 5.5

5.0 The sharp fall in long-term yields in January 2006 continued Sterling the downward drift in global real rates under way since the end 4.5 of 2003.(1) Market contacts suggest that the sharp fall in long-term real yields in the United Kingdom was given further 4.0 impetus by an imbalance between the supply of long-dated UK Euro 3.5 government bonds and the demand for these instruments by 3.0 pension funds and insurance companies seeking to match a 2.5 higher proportion of their bond-like liabilities. Their attempts 2.0 to ‘search for safety’ by hedging their liabilities in this way may 0.0 0 5 10 15 20 25 have created a feedback effect by lowering the discount rates Years ahead used to value the liabilities. Higher valuation of liabilities then Source: Bank of England. resulted in further demand for long-dated bonds for hedging (a) Instantaneous forward rates derived from the Bank’s government liability curve. purposes. These dynamics may have contributed to the yield (b) Solid lines at 26 June 2006, dashed lines at December 2005 FSR. on 50-year RPI-indexed bonds falling to an intraday low of 0.4% on 17 January. Chart B Changes in nine-year forward rates(a) These market microstructure effects seem to have persisted at Nominal forward rate Darker area of bars represents real rates the very long end of the yield curve in the United Kingdom. Lighter area of bars represents derived inflation expectations Percentage points Chart A shows that the increases in long-term government 1.0 yields reflect higher forward rates at all future horizons in the 0.8

United States and the euro area. In the United Kingdom, 0.6 however, forward rates are higher only at short and 0.4 medium-term horizons; beyond a 20-year maturity they 0.2 have fallen further since the December 2005 FSR. + 0.0 – Government bond yields bounced back across the major 0.2 economies between January and May. The decomposition of 0.4 changes over this period in Chart B shows that while implied 0.6 inflation expectations nudged up during this period — for 0.8 example, by about 15 basis points at the nine-year maturity 1.0 Jan. 2005 Jan. 06 – Jan. 05 – Jan. 06 – Jan. 05 – Jan. 06 – in the United States — they do not account for most of the – Jan. 06 May 06 Jan. 06 May 06 Jan. 06 May 06 rise in yields. US dollarSterling Euro Sources: Bank of England and Bloomberg. Most of the increase appears to reflect higher global real rates. (a) Real component of euro rates implied by nominal government bond yields less inflation swap rates. Sterling and dollar real rates derived from the Bank’s government liability curves. It is difficult to identify precisely the causes of this rise. In part, it may simply represent a correction of a previous misalignment. Analysis of changes in international real forward rates suggests an increase in the explanatory power of a common factor in recent months. So a significant proportion (1) Possible explanations for the decline in global real interest rates have been discussed in a number of Bank of England Quarterly Bulletins. See, for example, page 6 of the of the increase appears to be a common global effect. In Spring 2006 Quarterly Bulletin. general, long-term real rates should be determined by the (2) This is discussed in the Bank of England Quarterly Bulletin, Summer 2006, which highlights the increased correlation between short-term nominal and long-term real balance of savings and investment. So one possibility, given rates in recent years. Section 1 Shocks to the UK financial system 21

Box 2 tranches are closest to risk-free securities because they have Collateralised debt obligations and risk only a remote possibility of losses. These are often held by monoline insurers with AAA ratings. Collateralised debt obligations (CDOs) are securities issued in Financial engineering of this type does not alter the financial tranches of varying seniority backed by a portfolio of credit sector’s aggregate credit exposure to the non-financial sector. instruments such as bonds or loans. The first few per cent of It does, however, alter the distribution of risk within the credit losses on the underlying portfolio are allocated to the financial sector by concentrating it in some securities and ‘equity’ tranche, the next few per cent to the ‘mezzanine’ reducing it in others. This can improve systemic stability if risk tranche and any further losses to more senior tranches. is held by those with the greatest capacity to absorb losses. The market for CDOs has grown rapidly in recent years, with One possible benefit to systemic stability of CDOs of ABS global funds invested in them now close to US$ 1 trillion — a comes from diversification because they contain a wider figure comparable to funds under management with hedge portfolio of underlying credits. The ABS in the CDOs may be funds.(1) Recently, CDOs backed by portfolios of asset-backed related to very different types of exposures across both the securities (ABS), notably based on home-equity loans and household and corporate sectors. This means that holders of commercial mortgages, have become popular. These securities CDOs of ABS have only a modest vulnerability to idiosyncratic take risk tranches (often a mix of high risk mezzanine and defaults that would affect just a few of the ABS. But investors lower risk senior tranches) from several ABS and repackage in these securities are vulnerable to macroeconomic risks that these risks into new securities of different seniority (Chart A). affect many of the underlying ABS at the same time.(2) US issuance of CDOs of ABS more than doubled in 2005 to around US$ 120 billion. Systemic stability also relies on investors knowing what risks they are bearing. The very complexity of these instruments Chart A CDO of ABS makes it difficult for investors to determine precisely how ABS exposed they are to particular risk factors. The potential Senior Commercial losses, and hence the market values, of CDO tranches are mortgage- Mezzanine backed dependent on default correlations within the existing portfolio, CDO Equity securities which are difficult to calibrate. Senior Mezzanine Mezzanine ABS Modelling difficulties can also lead to errors in hedging, so ABS Equity traders can find themselves with residual exposures that they Senior Home- equity thought they had hedged. In such situations, they may wish to Mezzanine loans Equity reduce the residual exposure if credit losses rise. But with the liquidity of CDO markets still developing, especially for some of the more complex instruments, a shortage of secondary In general, equity tranches of CDOs have high expected losses market liquidity could potentially amplify price movements in and their value is very sensitive to changes in default the event of a shock. prospects. Reflecting this, equity tranches pay high yields. Investors are compensated for the higher risk of equity tranches by receiving an upfront fee plus a fixed annual spread. They have been popular with hedge funds and other investors searching for yield in an environment of low risk-free interest rates. They are also often held by originating banks or the CDO managers (increasingly hedge funds themselves), which take the first-loss position to demonstrate their commitment to monitor the credit quality of the underlying portfolio.

Mezzanine tranches usually have investment-grade credit ratings and are attractive to institutional investors who cannot invest in sub-investment grade claims. But their pay-offs are highly non-linear. For example, investors in a 3%–7% mezzanine tranche suffer no loss of principal if the loss rate on (1) The market is even larger when synthetic CDO investments are included, but the data the portfolio of underlying securities is less than 3%, but lose on these are incomplete. (2) See also Belsham, T, Vause, N and Wells, S (2005), ‘Credit correlation: interpretation all of their principal if it is more than 7%. The most senior and risks’, Bank of England Financial Stability Review, December, pages 103–15. 22 Financial Stability Report July 2006

Chart 1.17 UK and international equity indices substantial impact on asset prices. In February, Iceland’s credit rating was downgraded and the Icelandic krona subsequently FTSE 100 FTSE All-Share depreciated by 15%. Because holding Icelandic bonds was a MSCI Global MSCI emerging markets Index: 4 Jan. 2005 = 100 prominent example of a high-yield strategy where risk had 170 materialised, it prompted a reassessment of investment in 160 countries with similar structural characteristics, such as Hungary and New Zealand (Chart 1.20). There was also a 150 sell-off in Middle Eastern stock markets. Major developed 140 capital markets were, however, largely immune to these 130 developments.

120 Starting in May, there has been a more sustained and 110 wider-ranging correction in risky asset prices. The price

100 adjustment was felt most strongly in asset classes that had risen most steeply over the preceding period — hence 90 Jan. Mar. May July Sep. Nov. Jan. Mar. May ‘correction’ — and was focused among assets towards the 2005 06 riskier end of the spectrum (Table 1.A). Emerging market Sources: Bloomberg and Bank calculations. and sub-investment grade spreads have risen on average by around 50 basis points and 30 basis points respectively from their low points. And spreads for some individual borrowers Chart 1.18 Implied equity market volatility(a) have increased by much more than these averages — for

Per cent example, by 150 basis points for Turkish sovereign bonds 50 since end-April. Spreads on equity and mezzanine CDO FTSE 100 45 tranches have retraced most of their falls since the December 40 2005 FSR. Global equities have fallen by about 10% from 35 their peak during early May and industrial metals prices S&P 500 30 are around 20% lower. Low-risk assets adjusted the least, 25 with investment-grade corporate bond spreads rising by 20 5 basis points.

15

10 In line with these movements, market volatility and

5 correlations have risen. The 30-day historical volatility of the FTSE 100 has risen from 10% to 20% and the distribution of 0 1990 92 94 96 98 2000 02 04 06 daily returns has been much wider since the beginning of May Sources: Bloomberg, CME, Euronext.liffe and Bank calculations. (Chart 1.21). As a result, the price of protection against equity (a) Three-month (constant maturity) implied volatilities. price variability — as measured by implied volatility — has risen sharply (Chart 1.18). Correlations between asset price movements have risen sharply to levels last seen around the Chart 1.19 Common component in asset prices(a) time of the invasion of Iraq in 2003 (Chart 1.19). Per cent 70 …though assets remain richly priced and risk expectations 65 low. 60 Average Looking over a longer period, asset prices across a wide range of 55 asset classes — bonds, equities, commodities, housing, and 50 commercial property — appear to remain high relative to their 45 expected future income streams, at least based on historical 40 trends. For example, notwithstanding recent falls, equity prices 35 are still similar to levels at the start of the year and are 30 substantially higher than their trough in 2002 (Table 1.A). And 25 emerging market bond spreads and sub-investment grade 20 corporate bond spreads are lower than at the time of the 0 1998 99 2000 01 02 03 04 05 06 December 2005 FSR. While volatilities and correlations Sources: Bloomberg and Bank calculations. between these assets increased sharply during May and June, (a) Proportion of variation in global equities, emerging market equities, commodities and they remain well below previous episodes of market turbulence. ten-year US Treasury yields explained by a common component over a three-month rolling window. Measures of market liquidity suggest this remains plentiful too. Section 1 Shocks to the UK financial system 23

Chart 1.20 High-yield exchange rates(a) And recent asset price movements, although larger than in the immediate past, have not resulted in market disorder. Icelandic krona Hungarian forint The Bank’s market intelligence indicates that market events New Zealand dollar Index: 3 Jan. 2005 = 100 130 during May and June may have checked risk appetite, at least among some institutions. Private sector surveys of investor sentiment have reached a similar conclusion.(1) But taken 120 together, this evidence does not suggest a fundamental rethink of risk preferences and risk strategies by financial markets has taken place. 110 Recent events, and financial markets’ response to them, may, however, be important as a signal of the potential sensitivity of 100 asset prices and financial positions to future disturbances. Current levels of asset prices appear still to be based on

90 optimistic expectations about future risks and uncertainties, Jan. Apr. July Oct. Jan. Apr. 2005 06 including about the macroeconomic outlook. These

Sources: Bloomberg and Bank calculations. expectations, while less strongly held than six months ago, are

(a) US dollars per currency unit. still the central view of the majority. Recent market movements illustrate the potential consequences of these expectations changing quickly. And as Section 3 discusses, in Table 1.A Price changes of risky assets the event of a sharp fall in asset prices, some of the underlying vulnerabilities in the balance sheets of corporates, households October Peak in Changes and, ultimately, financial institutions could be exposed. 2002 to 2006 to since peak(a) 26 June Dec. in 2006 2006 2005 FSR

MSCI world equity index(b) +84 –10 +3 MSCI emerging markets equity index(b) +216 –21 +4 Industrial metals price index(b) +258 –19 +39 Investment-grade bond spreads(c) –113 +5 –2 Sub-investment grade bond spreads(c) –535 +32 –29 Emerging market bond spreads(c) –545 +52 –7

Sources: Bloomberg, Goldman Sachs, JPMorgan Chase & Co., Merrill Lynch, Thomson Financial Datastream and Bank calculations.

(a) The peak date is the 11 May 2006 for all series, except for the emerging markets bond index, emerging markets equity index and the world equity index for which 3, 8 and 9 May 2006 are used respectively. (b) Per cent. (c) Basis points.

Chart 1.21 Daily changes in FTSE 100

2005 January 2006–April 2006 May 2006–26 June 2006 Frequency 0.40

0.35

0.30

0.25

0.20

0.15

0.10

0.05

0.00 <-1.5-1.5 -1.0 -0.5 0.0 0.5 1.0 >1.5 to to to to to to -1.0 -0.5 0.0 0.5 1.0 1.5 Percentage change

Sources: Bloomberg and Bank calculations. (1) For example, see the survey in Goldman Sachs’ Portfolio Strategy, 1 June 2006. 24 Financial Stability Report July 2006

2 Structure of the UK financial system

Growth in UK bank lending to the UK household sector has continued to slow in parallel with a sharp increase in write-off rates on unsecured lending. But growth in lending to the corporate sector remains strong, in particular to UK commercial property companies. The major UK banks are also continuing to increase their participation in the syndicated loan market and are increasingly reliant on wholesale sources of funding. This leaves them more vulnerable to falls in market liquidity. They maintain large exposures to large complex financial institutions (LCFIs), whose profitability has increased because of record trading revenues. Competitive pressures to increase revenues may, however, be outweighing concerns about balance sheet risks across the financial sector.

This section discusses recent developments in the structural characteristics of the UK financial system — in particular, Chart 2.1 The major UK banks’ aggregate balance sheet among the UK banks — and how they relate to the as at end-2005 macroeconomic and capital market developments discussed in Rest of world 12% Section 1.

United States 12% 41% Customer deposits Structure of the major UK banks’ balance sheet. Rest of Europe 16% Chart 2.1 shows a stylised representation of the major UK

Deposits from banks’ aggregate balance sheet at the end of 2005.(1) UK 11% (a) banks banks maintain a large exposure to domestic credit and Other UK 33% exposures(b) 18% Debt securities interest rate risk through their lending to the UK household and corporate sectors. This accounted for just over a quarter UK corporate 6% of total assets at end-2005. Exposures to overseas borrowers 26% Other liabilities(c) UK household 20% represented two fifths of the major UK banks’ total assets. The 4% Tier 1 capital(d) rest of Europe and the United States account for the majority Assets Liabilities of the major UK banks’ foreign assets, though claims on Sources: Bank of England, Financial Services Authority (FSA) regulatory returns and published accounts. emerging market economies (EMEs) have been rising and

(a) Deposits from banks include borrowing from major UK banks. accounted for over 17% of total foreign assets at the end (b) Other UK exposures include (among other items) loans to UK-resident banks and other financial corporations and holdings of UK government debt. of 2005.(2) (c) Other liabilities include Tier 2 capital, short positions, insurance liabilities and derivative contracts with negative marked-to-market value. (d) Assets are not risk weighted. As a percentage of risk-weighted assets, Tier 1 capital is 8%. (1) Membership of the major UK banks group is based on the provision of customer services in the United Kingdom, regardless of the country of ownership. The following financial groups, in alphabetical order, are currently members: Alliance & Leicester, Banco Santander, Barclays, Bradford & Bingley, HBOS, HSBC, Lloyds TSB, Nationwide, Northern Rock and RBS. (2) Claims are calculated on an ultimate risk basis to ensure that exposures are allocated to the country where the credit risk ultimately lies. See Box 6 on page 34 of the June 2005 FSR. Section 2 Structure of the UK financial system 25

The major UK banks are further exposed to counterparty credit and interest rate risk through their lending to each other and to other financial institutions, most notably the non-UK LCFIs.(1) They are also exposed to market and liquidity risk through their wholesale funding and trading activities, where the latter are concentrated among the internationally active banks. Through all of these activities, the major UK banks also Chart 2.2 Major UK banks’ annual write-off rates(a)(b)(c) have an indirect exposure to LCFIs, who act as key

Mortgage Total household(d) intermediaries in domestic and global capital markets. Credit card Corporate Other unsecured Per cent Additional risks to the major UK banks’ balance sheets arise 5.5 through their common dependence on key market 5.0 infrastructures. 4.5

4.0

3.5 Growth in UK banks’ unsecured lending continues to slow…

3.0 The major UK banks’ exposures to UK households are

2.5 predominantly secured on residential property. At the end

2.0 of March 2006, mortgage lending accounted for 87% of the 1.5 major UK banks’ stock of lending to UK households. UK 1.0 banks’ write-off rates on mortgage lending are much lower 0.5 than those on unsecured lending and remained at extremely 0.0 low levels during 2005 (Chart 2.2). The annual growth rate 1999 2000 01 02 03 04 05 06 of mortgage lending slowed during the fourth quarter of Source: Bank of England. 2004 and the first half of 2005, but has since levelled off; it (a) Data exclude Nationwide. was just under 8% in the year to April 2006 (Chart 2.3). (b) Write-off rates are dependent on specific bank policies, which may vary over time. (c) Write-off rates on lending to UK residents. According to market contacts, some lenders have (d) ‘Total household’ is the sum of mortgage, credit card and other unsecured. increased their maximum loan to value (LTV) ratios, although average ratios on new lending remain considerably lower than during the early 1990s. And while the UK sub-prime mortgage market has grown rapidly in recent years, the exposure of the major UK banks to this sector remains Chart 2.3 Major UK banks’ annual growth in lending to small. UK households(a)(b)

Per cent 30 As Section 1 discussed, rising UK household indebtedness is creating pockets of vulnerability. During 2005, there was a Credit card 25 sharp rise in annual write-off rates on unsecured lending by UK banks, with the annual write-off rate on credit cards reaching 20 5.1% in 2006 Q1 (Chart 2.2). Partly reflecting a possible change in attitudes towards bankruptcy, this may have raised 15 uncertainties among banks about household credit risk, particularly for unsecured lending. Contacts report that the Other unsecured 10 major UK banks have tightened their lending criteria further over the past six months. Interest rate spreads on some credit Mortgage 5 cards have been widening and banks have been restricting

0 credit availability for some borrowers, including the highly 1999 2000 01 02 03 04 05 06 indebted. Reflecting this, the annual growth rate of unsecured Source: Bank of England. lending to households continued to slow during 2005 Q4 and (a) Data exclude Nationwide. (b) Data are for individuals; unincorporated businesses excluded. 2006 Q1; credit card lending experienced the sharpest deceleration, to a twelve-month growth rate of 6.4% in April 2006 (Chart 2.3).

(1) LCFIs include the world’s largest banks, securities houses and other financial intermediaries that carry out a diverse and complex range of activities in major financial centres. The group of LCFIs is identified currently as: ABN Amro, Bank of America, Barclays, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase & Co., Lehman Brothers, Merrill Lynch, Morgan Stanley, RBS, Société Générale and UBS. 26 Financial Stability Report July 2006

Chart 2.4 Major UK banks’ annual growth in lending to …while UK commercial property lending remains strong… UK non-financial companies(a) With corporate insolvencies remaining very low, annual

Per cent write-off rates by UK banks on corporate loans were only 0.5% 35 in 2006 Q1 (Chart 2.2). But as noted in Section 1, there are

30 signs that the corporate credit cycle could be turning. Some of Real estate the major UK banks warned in their annual accounts that 25 impairment charges, which had been particularly low in 2005,

20 could rise in 2006. Despite slowing from an average annual growth rate of 15% in 2005, major UK banks’ lending to 15 domestic non-financial companies is still strong, at an annual rate of just under 13% in March 2006 (Chart 2.4). 10 Total(b)

5 The commercial property sector has been a source of substantial credit losses for UK banks in the past, with 0 1999 2000 01 02 03 04 05 06 write-offs tending to be more cyclical than on other corporate Source: Bank of England. exposures. Exposures to UK commercial property companies(1) (a) Data exclude Nationwide. accounted for only 2.4% of the major UK banks’ total assets at (b) Total lending to non-financial companies including lending to real estate companies. the end of 2005, but these exposures are highly concentrated Chart 2.5 Major UK banks’ dealing profits as a among lenders. Despite having recently slowed, the annual percentage of operating income(a)(b) growth rate of lending by the major UK banks to the UK

Per cent commercial property sector remains strong, at around 13% in 14 Maximum-minimum range March 2006 (Chart 2.4). Moreover, for the second consecutive Interquartile range 12 Median year, margins and interest cover on property lending have (2) 10 fallen while average LTV ratios have risen. Speculative office development has also been increasing rapidly and there is 8 some concern about potential oversupply from around 2009.(3) 6

4 …and syndicated lending activity continues to grow… Exposures to the corporate sector, in particular highly 2 + leveraged companies, may also have been growing because of 0 the major UK banks’ increasing trading activities and – participation in the primary debt capital markets. These 2 199899 2000 01 02 03 04 05 activities remain concentrated among a few major UK banks. Sources: Published accounts and Bank calculations. For those banks, exposure to market and liquidity risks may (a) Data are for those major UK banks that report dealing profits. also have been increasing (see Box 3); the median contribution (b) Due to changes introduced under International Financial Reporting Standards (IFRS), figures for 2004 and 2005 use the most comparable data possible. of dealing profits to income has been steadily rising and is now around 6% (Chart 2.5). Chart 2.6 Major UK banks’ participation as lead arranger in global syndicated lending(a)(b) Syndicated lending activity by participating UK banks has been US$ billions 450 growing rapidly over the past three years (Chart 2.6). The LBO/MBO-related loans Other leveraged loans 400 value of loans where one of the UK banks acted as a lead Other syndicated loans arranger(4) during 2005 was equivalent to 9.2% of the major 350 UK banks’ total assets at end-2005. The ultimate risk to banks’ 300 capital depends on the extent to which these exposures are 250 sold on or hedged, which is difficult to assess. Leveraged

200 lending is a specific type of syndicated lending that is typically

150

100 (1) This includes companies involved in the development, buying, selling and renting of real estate. Exposures do not include banks’ holdings of commercial 50 mortgage-backed securities or loans to other companies collateralised by UK real estate. 0 199798 99 2000 01 02 03 04 05 06(c) (2) Maxted, W and Porter, T (2006), ‘The UK commercial property lending market’, De Montfort University. Sources: Dealogic and Bank calculations. (3) Drivers Jonas’ Central London Crane Survey, 2006 Q1, available at www.driversjonas.com/uk.aspx?doc=17283. (a) Includes cancelled loans, but excludes amendments and unsigned loans. (b) Where the actual proportions provided by each syndicate member are unknown, loan (4) Lead arrangers are the set of banks that manage the syndication process, including amounts have been split equally among participating banks. selling the deal to the market and offering bridging finance, a facility that may or may (c) 2006 figures are year-to-date. not be called. Section 2 Structure of the UK financial system 27

Box 3 and evaluate their risks will turn out to be inaccurate during Trading revenues and Value-at-Risk times of stress.(2) Chart B LCFIs’ Value-at-Risk(a)(b) In recent years, some UK banks have expanded their trading Equity Other Total VaR activities, so the contribution of dealing profits to income has Fixed income Diversification US$ billions 5 been steadily rising (Chart 2.5). Unsurprisingly, this has been accompanied by larger trading book exposures to market risk, 4 as proxied by disclosed Value-at-Risk (VaR) measures.(1) 3 However, VaR measures have not risen as much as the rise in trading income might suggest — the ratio of dealing profits to 2 VaR has been rising (Chart A). A similar picture emerges for 1 the LCFIs over the past year. These institutions experienced a + 50% increase in trading revenues in 2005, but this was 0 accompanied by only a relatively small increase in their VaR – (Chart B). This could mean that firms are diversifying their 1 portfolios more efficiently. But it may also support the widely 2 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 held view that VaR is an imperfect measure of risk in the 2004 05 06 trading book. Sources: Published accounts and Bank calculations.

(a) Standardised to US dollar, 99% confidence interval and a ten-day holding period. (b) Data for selected LCFIs, where data are available. Chart A Major UK banks’ dealing profits as a multiple of Value-at-Risk(a)(b) These limitations highlight the need to complement Ratio 45 VaR-based analysis with other risk measurement and Maximum-minimum range Interquartile range 40 management tools, such as stress tests. This need is Median well-recognised by most financial firms and so VaR is likely to 35 be only one of a range of tools used by firms to manage 30 trading positions. VaR is, however, reportedly being used by a 25 number of firms as the basis for calculating initial margins on 20 collateralised lending. This convention could have amplifying

15 effects on asset prices. For example, a significant rise in VaR could cause prime brokers to increase their margin 10 requirements on lending to hedge funds, perhaps triggering a 5 sale of assets.(3) 0 2002 03 04 05 VaR measures are based on estimates of the volatility of asset Sources: Published accounts and Bank calculations. returns and the correlation between them. The simplest (a) Data are for those major UK banks that report dealing profits. (b) Average Value-at-Risk standardised to sterling, 99% confidence interval and a ten-day approach to deriving volatility and correlation estimates is to holding period. use historical data. But as discussed in Section 1, both volatility and correlation have been low recently, at least prior One explanation for this is that VaR does not measure the to the market correction that began in May. Based on such expected loss of the portfolio; it indicates only the maximum backward-looking measures, current measures of VaR might loss that is likely to occur with a given level of confidence over therefore be understating risk — for example, low historical a certain horizon. Moreover, VaR was developed principally as correlation estimates may be overstating the diversification a tool to measure market risk, as encapsulated in asset price effect in Chart B, which increased during 2005 and the first movements. So it may not fully capture a number of other quarter of 2006. A sustained rise in volatility and/or risks increasingly inherent in the trading books of major UK correlation should feed through to higher VaR-based measures banks and LCFIs but not reflected in market prices. For of risk, other things being equal. That could in turn amplify example, some assets in the portfolio may have high levels of downward asset price movements due to VaR-based margining liquidity risk — so that a fall in market liquidity has a large conventions. impact on prices — but this may be difficult to quantify. There may also be some model risk associated with the (1) The VaR of a portfolio measures the maximum loss likely to occur over a chosen holding period with a certain level of confidence. Equally, it describes the minimum pricing of credit derivatives and other structured products. loss likely to occur for a given probability. Given the lack of data on more innovative and complex (2) See (2006) Banque de France, Financial Stability Review, May, pages 51–61 and page 37 of the December 2005 FSR for a further discussion of these issues. instruments, it is possible that the models used to price them (3) See Box 5 for a more general discussion of financial market amplifiers. 28 Financial Stability Report July 2006

extended to sub-investment grade borrowers and allows them to take on particularly high levels of debt relative to equity. Chart 2.6 shows that most of the leveraged loan business in which the major UK banks have been involved has been leveraged buyout (LBO) related. As Section 1 discussed, this has been an area of heightened activity in recent years and the Chart 2.7 Major UK banks’ customer funding gap(a) average leverage ratio for a typical European LBO has risen.

£ billions 500 Acting as a lead arranger on these deals may involve taking a large exposure for a short period of time — for example, in the IFRS break 400 form of a bridge loan — until other financing, often a high yield bond issue, can be arranged for the borrower. These 300 short-term loans may be significantly larger than the amount a lender would be willing to provide on a continuing basis. In 200 this way, the major UK banks are effectively ‘warehousing’

100 risks that they intend to remove from their balance sheets + when longer-term funding can be secured. The ability of lead 0 arrangers to secure longer-term funding may depend on the – financial environment remaining stable. This raises the 100 199899 2000 01 02 03 04 05 possibility that, in the event of an unanticipated sudden

Sources: Published accounts and Bank calculations. deterioration in market conditions, the participating major UK

(a) Data for 2004 and 2005 include securitised assets due to IFRS. banks (as well as other lead arrangers such as the non-UK LCFIs) could find themselves holding large, potentially overvalued, exposures.

…with funding more reliant on wholesale markets… A further vulnerability to market conditions is evident on the liability side of the major UK banks’ balance sheets. The (1) Chart 2.8 Major UK banks’ maturity breakdown of customer funding gap, which describes the amount of wholesale funding(a)(b)(c) customer lending not financed through customer deposits, increased further in 2005 (Chart 2.7). At end-2005, it stood at Greater than five years Less than five years but greater than one year almost £500 billion, or 11% of the major UK banks’ total Less than one year but greater than three months Less than three months Per cent assets. This implies a greater reliance on sources of wholesale 100 funding. These can take various forms, including interbank 90 borrowing and the issuance of debt securities, such as 80 mortgage-backed securities (MBS) and certificates of deposit 70 (CD). These sources of funding tend to be more expensive 60 than customer deposits and, with the notable exception of 50 MBS and some asset-backed securities, need to be rolled 40 over.(2) So their cost and availability is much more sensitive to 30 market conditions. Concentrations among issuers or lenders

20 could have a negative impact on liquidity in particular

10 wholesale funding markets. In the sterling CD market, for

0 example, the proportion of issuance accounted for by the 2001 02 03 04 05 largest UK banks has been increasing in recent years. Sources: Published accounts and Bank calculations. (a) Wholesale funding consists of debt securities in issuance and interbank deposits. The major UK banks have responded to some of these (b) Debt securities in issuance of maturity less than three months are estimated where necessary. concerns by diversifying their funding sources and extending (c) Data for 2004 (where available) and 2005 include outstanding securitisations due to IFRS. the maturity over which they borrow. At end-2005, just under 50% of their wholesale funding had an outstanding maturity of greater than three months, compared to just

(1) Customer funding gap is customer lending less customer funding, where customer refers to all non-bank borrowers and depositors. (2) Mortgage-backed securities provide matched funding for mortgage lending. Around half of the increase in the customer funding gap from 2004 to 2005 was met by securitisations. Section 2 Structure of the UK financial system 29

Chart 2.9 Major UK banks’ ‘large exposures’ to banks over 40% at end-2004 and around 34% at end-2001 and LCFIs by counterparty, end-March 2006 (Chart 2.8).

Major UK banks Other European banks Non-UK LCFIs Other banks …and ‘large exposures’ to LCFIs increasing. Benelux banks 6% Activity in the interbank market exposes the major UK banks 6% to counterparty credit risk. At the end of 2005, the stock of

4% interbank lending (combining secured and unsecured lending) 31% was equivalent to over 200% of UK banks’ Tier 1 capital. Exposures also arise through off balance sheet transactions between the major UK banks and other financial institutions, including the non-UK LCFIs. Regulatory ‘large exposures’ data capture both on and off balance sheet items.(1) The major UK banks’ large exposures to non-UK LCFIs stood at £98 billion at the end of March 2006, equivalent to 63% of their Tier 1 capital. This exposure was up from £69 billion at end-2005 53% and represented 53% by value of the major UK banks’ large

Sources: FSA regulatory returns and Bank calculations. exposures to banks and LCFIs (Chart 2.9). It is larger than the sum of bilateral large exposures within the set of major UK banks, of around £58 billion. Chart 2.10 Incidence of common ‘large exposure’ counterparts during 2006 Q1 These large bilateral exposures are more important to the UK

Number of counterparties in category financial system the more frequently a particular institution 12 Major UK banks appears as a counterparty. Chart 2.10 shows the incidence of Non-UK LCFIs 11 Other banks large exposures (including banks, LCFIs and — by way of 10 Industrials comparison — industrials) across the ten major UK banks 9 8 during 2006 Q1. The more exposures there are to a particular 7 counterparty, the greater the number of UK banks that would 6 incur a significant loss in the event that counterparty fails. 5 During 2006 Q1, there were twelve financial institutions that 4 five or more of the major UK banks shared as a large exposure 3 counterparty. Five of these institutions were other major UK 2 banks and five were non-UK LCFIs. 1 0 2345678910 These data illustrate the strong links that exist between the Number of exposures major UK banks and LCFIs. They underscore the importance of Sources: FSA regulatory returns and Bank calculations. these institutions to the UK financial system, as key intermediators of risk and as providers of liquidity to the capital markets. Chart 2.11 Major UK banks’ and LCFIs’ credit default swap premia(a) Market-based expectations of LCFI default probabilities US securities houses European LCFIs US commercial banks Major UK banks Basis points 110 remain low…

100 The market’s assessment of the default probability of LCFIs —

90 as proxied by credit default swap (CDS) premia — has

80 remained low over the past six months, although premia

70 have risen since market volatility began to pick up recently

60 (Chart 2.11). For example, CDS premia for the US securities

50 houses have risen, on average, by around 10 basis points

40 since the beginning of May. This is the largest sustained rise

30 in CDS premia since May 2005, following the market

20 reaction to the downgrade of General Motors (GM) and

10 Ford. However, CDS premia remain lower than they

0 were a year ago and the response of prices to the recent 2002 03 04 05 06

Sources: Bloomberg, Markit and Bank calculations. (1) For regulatory purposes, ‘large exposures’ are defined as any exposures that exceed (a) Average premia weighted by total assets. 10% of eligible capital (Tier 1 plus Tier 2 capital, less any regulatory deductions). 30 Financial Stability Report July 2006

Chart 2.12 Major UK banks’ and LCFIs’ return on period of market volatility has been more modest than in common equity May 2005.

US securities houses European LCFIs(a) US commercial banks Major UK banks(a)(b) Per cent 25 …with LCFI profits strong across the sector… In large part, this relatively muted response may reflect the continuing high profitability of LCFIs. As a group, the earnings 20 performance of the LCFIs was strong during 2005 (Chart 2.12). The largest contribution to the rise in the revenues of the LCFIs 15 came from their trading activities (Chart 2.13). This revenue stream includes profits both from trading client flows and from 10 taking positions on a proprietary basis. Aggregated across the peer group, revenues from these activities rose by around 50% 5 to $120 billion in 2005. Trading revenues for the UK LCFIs doubled, in aggregate, over the same period. For those LCFIs

0 that report quarterly figures, this strong growth continued into Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 2003 04 05 06 2006 Q1. It is too soon to assess fully the impact of market

Sources: Bloomberg and Bank calculations. conditions since May on trading revenues. But results for the

(a) Data for European LCFIs and major UK banks are half yearly. US securities houses for the second quarter of 2006 suggest (b) Data exclude Nationwide. little impact to date.(1)

Chart 2.13 LCFIs’ revenue sources …resulting from an apparent increase in risk taking… A key factor in generating these revenues for the LCFIs appears Other operating income Net interest income Net fees and commissions Trading revenue US$ billions to have been a willingness to take on more risk. Contacts 700 report that firms have been extending their risk-taking 600 activities despite the view of many that the premium for taking on risk is currently too low. This may reflect concerns about 500 risks to future revenues and market share. In essence, business

400 risk may have been perceived as greater than the balance sheet risks associated with potentially overpriced assets. Consistent 300 with that, balance sheets have been growing strongly

200 (Chart 2.14) and there has been some increase in leverage (Chart 2.15).(2) 100

0 Peer group competition may have been an important factor 2000 01 02 03 04 05 shaping current attitudes towards risk. In the current Sources: Bloomberg and Bank calculations. environment, there are strong competitive incentives to grow revenues and enhance shareholder value by emulating the Chart 2.14 Major UK banks’ and LCFIs’ total assets business models of those LCFIs that have been particularly US securities houses profitable in recent years. Reflecting this, more than one LCFI US commercial banks European LCFIs has publicly declared its intention to take on more risk through Major UK banks(a) Index: end-2000 = 100 240 proprietary position-taking and trading.

200 As discussed in Section 1, demand for structured credit products is rising. Some tranches of bespoke structured deals 160 are likely to be at the less liquid end of the asset spectrum. Those institutions originating and distributing structured 120 products may be increasing their residual exposure to these assets, either directly through undistributed pieces of the deals 80 originated, or indirectly as LCFIs accept assets as collateral to

40 secure loans to hedge funds and other financial entities. For example, increasing competition among prime brokers has

0 2001 02 03 04 05 (1) Three LCFIs have a November financial year-end and so report Q2 results for March to Sources: Bloomberg and Bank calculations. May in mid-June. (a) Due to changes introduced under IFRS, figures for 2004 and 2005 use the most comparable (2) Gross leverage ratios may overstate the sensitivity of net worth to changes in data possible. underlying asset values (see Box 4). Section 2 Structure of the UK financial system 31

(1) Chart 2.15 LCFIs’ leverage(a) reportedly led, in some cases, to reductions in haircuts on high quality collateral and/or to a willingness by some dealers Maximum-minimum range Interquartile range to accept less liquid instruments as collateral. At the same Median Ratio 50 time, the LCFIs have sought to improve their liquidity 45 management — for example, the proportion of the US LCFIs’

40 debt maturing within five years fell from an average of 72% to

35 67% between 2002 and 2005, while the share of debt due

30 within one year fell from 22% to 15%. Holdings of ‘cash’ have

25 also risen at certain institutions.

20 …supported by strong hedge fund activity. 15 The activity of hedge funds continues to be supported by a net 10 inflow of capital. In the last quarter of 2005, hedge funds did 5 experience a net outflow of funds for the first time since 0 2001 02 03 04 05 2002 Q4. But this was more than reversed in the first quarter

Sources: Bloomberg and Bank calculations. of 2006, with net inflows reaching $27.6 billion (Chart 2.16).

(a) Leverage equals total assets divided by stockholders’ equity. As with LCFIs, relatively benign liquidity and volatility conditions may have encouraged greater leverage and risk taking among hedge funds in recent years. Leverage is difficult to measure, particularly so for hedge funds where the data are partial. Most estimates seem to suggest that while leverage is picking up, on average, it is not currently at particularly high levels (see Box 4). Chart 2.16 Net capital flows into hedge funds

Long/short equity Event driven Global macro Fixed income Given uncertainties about the precise balance sheet position of Emerging markets Equity market neutral Convertible arbitrage Managed futures hedge funds, it is difficult to know how they might respond to Dedicated short bias Multi-strategy US$ billions 50 a period of market turbulence. In May 2005, hedge funds were a useful source of liquidity, in particular in structured credit 40 markets, following concerns about prospects for GM and Ford. But hedge funds cannot automatically be relied on to alleviate 30 stresses in financial markets. For example, market contacts suggest hedge funds (and other active traders) may have 20 amplified volatility in asset prices during May and June, perhaps reflecting common strategies among these investors. 10 One key factor in determining hedge funds’ future behaviour is + 0 likely to be the response of their investors and prime brokers to – any deterioration in their returns (see Box 5).

10 199798 99 2000 01 02 03 04 05 06 Operational risks associated with over-the-counter (OTC) Source: Tremont Capital Management, Inc. derivatives are also a concern… Operational risk often arises when financial innovation outpaces risk management at financial firms and supporting infrastructure. A notable example is the back-office problems associated with the processing of certain OTC derivatives, particularly credit products — namely, delays in the confirmation, matching and assignment of trades. In the past year, an initiative launched by the Federal Reserve Bank of New York, in collaboration with the UK FSA, other international regulators and the financial industry, set ambitious targets for reducing these backlogs. So far, these targets have been hit by the majority of the large financial

(1) A ‘haircut’ is a percentage subtracted from the market value of an asset that is being used as collateral. The size of the haircut should reflect the perceived risk associated with the asset and therefore account for the potential decline in value that may occur before the asset can be liquidated. 32 Financial Stability Report July 2006

Box 4 leverage. But this delta can be difficult to calculate for whole Leverage portfolios. Hedge fund leverage Leverage increases the sensitivity of net worth to changes in To estimate hedge fund leverage, the Bank for International asset prices. It is obtained either through borrowing (balance Settlements (BIS) regresses the returns on a portfolio of hedge sheet leverage) or through off balance sheet transactions, such funds on a set of risk factors that are considered to affect the as derivative instruments, whose values fluctuate by a multiple returns on different asset classes. From this, the sensitivity of of the change in the underlying referenced asset (embedded their asset values to market prices can be estimated. This leverage). represents the combined effects of both balance-sheet and embedded leverage. Chart B suggests that total hedge fund Balance sheet leverage leverage was high before the LTCM crisis and peaked in early The simplest measure of balance sheet leverage is the ratio of 2000. The estimates corroborate reports from market the book value of total assets to the book value of equity. A contacts who suggest that hedge funds are generally not as more sophisticated measure is the net leverage ratio which is highly leveraged as they were in the late 1990s. However, it is calculated by first deducting from total assets forms of secured important to note that reporting coverage of the data is lending that are matched by secured liabilities, and then incomplete.(2) adding certain liabilities, such as short positions in (non-derivative) securities, that are affected by changes in market prices. As an illustration, Chart A shows that, while Chart B BIS indicators of hedge fund leverage(a)(b) gross leverage at the four largest US securities houses is now Total leverage(c) Equity funds back at the level of early 1999, the rise in net leverage has Fixed income funds Level been more modest. 5.0 4.5

4.0 (a) (b) Chart A Gross and net leverage of US securities 3.5 houses(c)(d) 3.0 Ratio 30 2.5

2.0 25 Gross leverage 1.5

1.0 20 0.5

Net leverage 15 0.0 199899 2000 01 02 03 04 05 06

Source: BIS. 10 (a) The estimate of leverage is based on a refinement of the procedure detailed in McGuire, P, Remolona, E and Tsatsaronis, K (2005), ‘Time-varying exposures and leverage in hedge funds’, 5 BIS Quarterly Review, March. (b) Leverage is estimated separately for different families of hedge funds by regressing hedge fund returns on a variety of market-based risk factors using a 24-month rolling regression window. 0 (c) Total leverage is the weighted measure of leverage for each hedge fund family (weighted by 1998 99 2000 01 02 03 04 05 06 the average assets under management over the 24-month window).

Sources: SEC filings and Bank calculations.

(a) Gross leverage equals total assets divided by stockholders’ equity. (b) Net leverage equals net assets divided by stockholders’ equity. Net assets equal total assets minus collateralised lending, plus securities sold but not yet purchased, minus derivative liabilities. (c) Calculations include Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley. (d) Annual data up until end-2004, quarterly data thereafter.

Embedded (risk-based) leverage A financial institution’s wider exposure to changes in market prices can be harder to identify because of the presence of embedded leverage. An interest rate swap or credit derivative, for example, may have zero value at inception and so will not appear on the balance sheet. However, by entering into the contract, an institution has increased its (1) Delta measures the ratio of the change in the price of the instrument to the change in the price of the underlying asset. exposure to changes in the price of the referenced index or (2) For a discussion of hedge fund data limitations see Box 10 pages 64–65 of the credit. In this case, the delta(1) is the appropriate measure of June 2005 FSR. Section 2 Structure of the UK financial system 33

Box 5 These financial market dynamics can become more acute Financial market amplifiers when a sustained fall in market liquidity coincides with or, in particular, triggers funding problems for institutions. Some examples in which the availability and cost of funding may be Various structural features of capital markets may amplify contingent on the performance of assets include: movements in asset prices. These mechanisms may temporarily push prices away from equilibrium levels — for • A reliance on unsecured lending. The cost and availability example, by causing prices to overshoot in response to a shock. of such funding depends on the credit quality of an This behaviour is likely in turn to have a negative impact on institution. An institution that suffers significant losses on market liquidity, regardless of whether or not the initial price its assets may therefore find itself unable to obtain sufficient movement was warranted. funding at reasonable cost on an unsecured basis. A topical source of market amplification derives from the • Margining of collateral. Secured lending backed by hedging of volatility or variance swaps. These are instruments collateral might also present a vulnerability if asset price through which investors can insure against large movements in falls lead to additional margin calls on the collateral posted, asset prices. Dealers buying these swaps take on the risk which might only be able to be met by liquidating other associated with an increase in volatility and can hedge their assets. Moreover, if margins are based on Value-at-Risk positions by selling a package of options. But this then (VaR) measures, a rise in market volatility or correlation exposes them to movements in the price of the underlying could trigger additional margin calls (see Box 3 for a general asset and so the options may in turn need to be hedged. In discussion of VaR). particular, a fall in the underlying asset price would require the dealers to sell assets. During the market turbulence in May, it • Constant proportion portfolio insurance (CPPI). These was reported that such hedging activity, in particular by LCFIs are transactions that include a specific provision that some and hedge funds, may have amplified volatility in the equity assets must be sold when the value of assets falls. They are markets.(1) designed to protect the investor against further losses. When the underlying assets are investments in hedge funds This is a specific example of a more generic source of market (through funds of funds based on CPPI structures), this amplification: investors who have sold options and need to requires a withdrawal of capital from those funds, which hedge their positions dynamically when prices fall.(2) Other might worsen selling pressure. possible amplifying mechanisms include:

There are many ways in which financial institutions can • Algorithmic trading funds. If funds hardwire trading attempt to mitigate these risks. For example, hedge funds decisions on the basis of trends or market momentum, a have recently sought to enforce ‘lock-ins’ for funding and to move in prices could be amplified by these funds’ actions. agree fixed margins on borrowing with their prime brokers (who are then exposed to greater counterparty credit risk if • Unwind of ‘carry trades’. Some trades may be profitable collateral values fall). In the United Kingdom, banks appear in only within a certain constellation of market prices. An recent years to have extended the maturity of their liabilities example is the so-called ‘carry trade’. The performance of to lower the proportion of their customer funding gap that these trades relies on the ability of the market participant to they would need to roll over during times of stress. fund a long position in an asset by rolling over short-term funding relatively cheaply. A narrowing of the spread between the expected risk-adjusted returns on the investment asset and the cost of funding can therefore prompt further moves as these trades are unwound.

• Asset-liability management. Institutions that aim to offset asset and liability risks, but are not as yet fully matched, may buy assets as prices rise and vice versa. An example is the fall in long-dated gilt yields discussed in Box 1; this raised the value of pension fund liabilities, leading some funds to demand more gilts. (1) See the box on equity variance swaps, Bank of England Quarterly Bulletin (2006), Summer, page 127. (2) A number of other examples were discussed in Box 9 of the June 2005 FSR, page 60 and Tucker, P (2005), ‘Where are the risks?’, Financial Stability Review, December, pages 73–77. 34 Financial Stability Report July 2006

Chart 2.17 Outstanding confirmations at large firms(a) firms, at least for standardised credit derivative products. However, further work needs to be done to address backlogs in Number of days 30 other products, some of which have increased in the past year (Chart 2.17). Looking further ahead, there is a case for a Credit derivatives 25 greater proportion of OTC derivatives being cleared centrally, to help reduce the scope for such problems. 20 Commodity derivatives

15 …as are dependencies on market infrastructures. Vanilla equity derivatives Another source of operational risk arises from the common

Vanilla interest rate swaps 10 dependence of financial institutions on certain key market infrastructures. All financial institutions rely on these 5 infrastructures to support payments, clearing and settlement of financial transactions. 0 2003 04 05

Source: ISDA Operations Benchmarking Survey (2006). The four market infrastructures on which financial institutions

(a) Confirmation backlogs are expressed in terms of the number of days worth of business, operating in the United Kingdom most rely are CHAPS (the calculated by dividing the number of outstanding confirmations by the daily volume of new trades. United Kingdom’s high-value payment system), CLS (a global exchange of value system in a number of foreign currencies), CREST (the United Kingdom’s securities settlement system) and LCH.Clearnet Ltd (the United Kingdom’s central counterparty for the clearing of derivatives and some cash markets). The value of transactions going through these systems is substantial — for example, daily averages in 2005 were around £300 billion per day in CREST and just under £210 billion per day in CHAPS.

As well as facilitating transactions, market infrastructures have Chart 2.18 Traffic sent in SWIFT by location of sending an important role to play in reducing the risks associated with entity 2005(a) these transactions. For example, central counterparties such

Traffic (left-hand scale) as LCH.Clearnet Ltd reduce counterparty risks by interposing Growth (right-hand scale)(b) themselves between buyers and sellers; while CHAPS settles Millions of messages Per cent payments gross and in real time allowing its participants to 500 25 exchange large values without incurring substantial intraday credit exposures. In CREST and CLS, participants settle both 400 20 legs of a transaction simultaneously, avoiding the credit risk associated with a timing mismatch. 300 15 Because payment and settlement systems are increasingly 200 10 closely linked, disruption to any of these infrastructures could lead to the build-up of significant settlement-related credit

100 5 and liquidity exposures on UK banks’ balance sheets.(1) A key source of interdependence among UK market infrastructures

0 0 arises from the role played by SWIFT — a provider of secure messaging services to support transactions between financial Italy Japan France Belgium

Germany institutions and infrastructures. CHAPS, CREST, CLS and Switzerland Netherlands Luxembourg United States LCH.Clearnet Ltd are all dependent on SWIFT messaging. This United Kingdom helps explain why the United Kingdom is the largest user of Source: SWIFT. SWIFT FIN(2) services internationally, as measured by traffic (a) Traffic refers to chargeable FIN messages. (b) Percentage growth in 2005 compared to 2004. sent (Chart 2.18). As Section 4 discusses, these

(1) Under the Memorandum of Understanding (MoU) between the Bank, the Financial Services Authority and HM Treasury, the Bank is responsible for overseeing payment systems that are of systemic significance to the United Kingdom. As part of discharging its responsibilities, the Bank publishes an annual Payment Systems Oversight Report, available at www.bankofengland.co.uk/publications/psor/psor2005.pdf. (2) SWIFT FIN is one of SWIFT’s core messaging services. Section 2 Structure of the UK financial system 35

interdependencies underscore the importance of each of these individual infrastructures, and the users of them, having adequate contingency plans to deal with an, albeit highly unlikely, operational disruption. 36 Financial Stability Report July 2006

3 Prospects for the UK financial system

The UK financial system has weathered well a series of disturbances over the past six months. Major UK banks’ reported profitability and capital levels have remained strong. But given its financial stability mandate, the Bank is monitoring a number of key vulnerabilities that could — in unlikely circumstances — potentially disrupt the UK financial system. Some of these vulnerabilities appear to have increased slightly since the December 2005 FSR. While the UK financial system remains highly resilient and the chance of these vulnerabilities crystallising is low, the impact in that unlikely event could be significant.

This section of the Report assesses the resilience of the UK financial system, in the light of developments in the macroeconomy and financial markets (discussed in Section 1) and in the structure of the system (discussed in Section 2).

3.1 UK banks’ resilience

UK banks’ financial buffers remain high. The UK financial system has been highly resilient over recent years in the face of a number of disturbances, including oil and Chart 3.1 Major UK banks’ pre-tax return on commodity price shocks and, most recently, sharp falls in equity(a)(b) some asset prices. There are several potential explanations for Maximum-minimum range Interquartile range this ongoing strength and flexibility. In part, it appears to Median Per cent 50 reflect improvements in risk management. Innovations in capital markets have also helped in the distribution of risk, in 40 particular credit risk, in the United Kingdom and 30 internationally. Finally, the UK financial system has accumulated significant financial buffers of profits and capital 20 over the past few years, which have helped insulate it from

10 disturbances. + 0 – Published accounts indicate that the profitability of the major 10 UK banks remained strong in 2005. Aggregate profits for the major UK banks were around £40 billion in 2005. The median 20 1998 99 2000 01 02 03 04 05 pre-tax return on equity for the nine listed banks fell slightly to Sources: Published accounts and Bank calculations. 21.1% in 2005, but remained high (Chart 3.1). The range of (a) Excludes Nationwide due to lack of data. outcomes narrowed somewhat, with all of the major UK banks (b) Pre-tax return on equity calculated as pre-tax profit as a proportion of shareholders’ funds and minority interests. having pre-tax returns on equity around or sometimes Section 3 Prospects for the UK financial system 37

substantially in excess of 20%. As Section 2 discussed, this Chart 3.2 Major UK banks’ Tier 1 capital ratios strong performance broadly mirrors the pattern seen by Maximum-minimum range Interquartile range financial institutions globally. Median Per cent 16

14 Major UK banks’ published capital ratios remain comfortably above Basel regulatory minima. At end-year 2005, both the 12 median Tier 1 and total capital ratios were broadly unchanged 10 on a year earlier at 7.9% and 12.0% respectively (Chart 3.2).

8 In levels terms, at the end of 2005 the major UK banks collectively had a published Tier 1 capital buffer of around 6 £160 billion. 4

2 3.2 What are the key vulnerabilities?

0 1998 99 2000 01 02 03 04 05 The Bank has explored six key vulnerabilities… Sources: Published accounts and Bank calculations. The Bank’s financial stability mandate requires it to consider not only the most likely outcome, but also major downside risks to the UK financial system. By their nature, these risks are likely to be few in number and the chance of them leading to Table 3.A Net assessment of news since the significant problems is very low. But to gauge the ongoing December 2005 FSR resilience of the system, and to help guide risk mitigation

A significant increase in risk Broadly unchanged work, it is nonetheless useful to assess and, where possible, A slight increase in risk A slight decrease in risk quantify their potential scale. A significant decrease in risk

VulnerabilityProbability(a) Impact(b) To that end, this Report explores six main sources of Low risk premia vulnerability for the UK financial system. None of them is new Global imbalances Global corporate debt and most are long standing. The characteristics of the UK household debt vulnerabilities themselves differ. Some arise from potential LCFI stress Infrastructure disruption mismatches or mispricing in international financial markets. Others are rooted in extended balance sheet positions in parts Source: Bank calculations. of the corporate and household sectors. Others still reflect (a) Assessed change in the probability of a vulnerability being triggered over the next three years. structural dependencies within the financial system. (b) Assessed change in the expected impact on major UK banks’ balance sheets if a vulnerability is triggered. Table 3.A summarises how news since the December 2005 FSR, discussed in Sections 1 and 2, has affected both the likelihood of problems arising through each of the key Chart 3.3 Bond spreads and equity indices vulnerabilities (probability) and their potential consequences

Corporate high-yield spread (right-hand scale) for the UK financial system (impact). So what are these key Emerging market sovereign bond spread (right-hand scale) vulnerabilities and how have they changed in the light of this MSCI world equity index (left-hand scale) news? MSCI emerging markets equity index (left-hand scale) Index Spread (basis points) 1500 1,500 Unusually low risk premia in asset markets. As Section 1 discussed, asset prices have risen considerably 1250 1,250 over the past few years, dwarfing recent price falls (Chart 3.3).

1000 1,000 Some of the drivers of rising prices — such as financial innovation that allows risks to be better matched to investors’ 750 750 preferences — are likely to endure. So risk premia may remain lower on average than in the past. But other factors that may 500 500 have boosted prices, such as low global risk-free yields and benign macroeconomic conditions, may not last indefinitely. 250 250 Against that backdrop, and despite recent market falls, the price of risk in financial markets still appears somewhat low. 0 0 1998 99 2000 01 02 03 04 05 06 Certainly, risk premia on a number of financial assets remain Sources: JPMorgan Chase & Co., Merrill Lynch and Morgan Stanley. low by historical standards. 38 Financial Stability Report July 2006

A sustained unwinding of the price rises seen in recent years across a range of asset markets — including equities, corporate and emerging market credits — would affect directly financial institutions with significant exposures to these assets, including large complex financial institutions (LCFIs), hedge funds and some internationally active UK banks. Other UK banks would also be affected indirectly through counterparty credit links and through dependencies on wholesale market funding. And all banks may face losses if asset price falls were accompanied by a substantial weakening in the financial position of borrowers.

In the early part of this year, benign macroeconomic developments were associated with a further rise in global asset prices across much of the risk spectrum. But more recently there have been signs of a shift in sentiment, manifest in sharp market adjustments during May and June. As Section 1 discussed, the net impact of these developments has been to take many asset prices back to around levels prevailing at the start of the year. That suggests that the likelihood of a sharp correction in risk premia is broadly unchanged over the period as a whole (Table 3.A). While it is too early to assess fully the consequences of recent market events, the apparent build-up in risk exposures in the early part of the year suggests that the likely impact on the UK financial system of any future correction in risk premia has probably increased slightly since December.

Large financial imbalances among the major economies. International financial imbalances have grown significantly in recent years (Chart 3.4). The US current account deficit has reached unprecedented levels and surpluses among Asian economies and, more recently, oil exporters have increased Chart 3.4 Global current account balances(a) markedly. These imbalances, and their associated financing, United States China cannot be sustained indefinitely. The question is whether the Oil exporters(b) Other EMEs(c) Japan Other advanced economies adjustment path towards more balanced global capital flows US$ billions 1,000 will be smooth or abrupt. Policies to support a smooth 800 adjustment have been identified, including by the G7.(1) But 600 while large imbalances persist, the risk remains of a disorderly

400 correction involving sharp movements in asset prices and

200 exchange rates. This could in turn affect the UK financial + 0 system through its potentially pervasive impact on capital – markets and asset prices, global growth and credit risks. 200

400 Section 1 noted that global imbalances are larger than they 600 were six months ago, suggesting that the potential impact of a 800 disorderly unwind may have increased slightly over the period 1,000 1990 94 98 2002 06(d) (Table 3.A). But the likelihood of such a disorderly adjustment

Source: IMF. may have decreased slightly, as US growth and interest rate

(a) Global current account balances do not sum to zero due to errors and omissions. differentials with other economies have narrowed and the (b) The sum of the ten largest oil exporters in 2004 — Algeria, Iran, Kuwait, Mexico, Nigeria, Norway, Russia, Saudi Arabia, United Arab Emirates and Venezuela. US dollar has depreciated. As Section 4 discusses, recently (c) Other EMEs includes the Newly Industrialised Asian economies. (d) IMF forecast, April 2006. agreed International Monetary Fund (IMF) procedures to

(1) See the statement by G7 Finance Ministers and Central Bank Governors, 21 April 2006, at www.ustreas.gov/press/releases/js4199.htm. Section 3 Prospects for the UK financial system 39

Chart 3.5 Leveraged loan issuance convene multilateral discussions, including on imbalances, may also in time support smooth adjustment. Leveraged(a) LBO US$ billions 900 (b) Rapid releveraging in parts of the corporate sector globally. 800 Corporate balance sheets are generally strong globally. Benign

700 macroeconomic conditions have helped keep insolvencies and write-offs on banks’ corporate exposures at very low levels. 600 But releveraging is taking place rapidly in some parts of the 500 corporate sector. As Section 1 discussed, leveraged loan 400 issuance, including to finance leveraged buyouts (LBOs), also 300 remains strong (Chart 3.5). Indeed, the threat of LBOs, often

200 involving private equity firms, may be encouraging a widening and deepening of corporate releveraging. UK bank lending to 100 the commercial property sector has also grown rapidly in 0 1997 98 99 2000 01 02 03 04 05 06 recent years. At the same time, strong competition for

Source: Dealogic. corporate exposures has meant margins on UK commercial

(a) Includes both leveraged and highly leveraged loans, typically priced at spreads of property lending have fallen further, while credit spreads on 150 basis points or more. (b) Data for 2006 are annualised based on Q1 and Q2. corporate debt are at historically low levels. Over time, these factors could add impetus to the accumulation of corporate sector debt, leading to a gradual build-up in this vulnerability.

Lending to UK companies accounts for around 6% of the total assets of the major UK banks; and UK banks also have significant overseas corporate sector exposures. Taken together, recent developments suggest that the potential impact on the UK financial system of any future shocks to corporate balance sheets has increased slightly over the past six months (Table 3.A). Although corporate profitability generally remains strong, rising input prices and tightening global monetary conditions may increase financial pressures on some companies. So the likelihood of such an event may have edged up too.

High UK household sector indebtedness. Over recent years, strong macroeconomic conditions, advances in credit risk management techniques and rising house prices have been accompanied by a rapid build-up in Chart 3.6 Ratio of household sector debt to annualised household indebtedness. Unsecured lending has grown post-tax income especially rapidly over the past five years; secured lending has Other(a) Unsecured debt also grown strongly. Higher asset prices, particularly rises in Mortgages Per cent 160 house prices, have boosted household net wealth. But higher debt levels mean households are potentially sensitive to 140 adverse shocks: the ratio of household debt to income has 120 risen from 100% in the late 1990s to around 150% (Chart 3.6).

100 UK household sector lending accounts for 20% of the total assets of major UK banks. The bulk is mortgage lending, where 80 low average loan to value ratios of around 45% provide a 60 substantial cushion to protect banks against losses. But

40 write-offs on unsecured lending have picked up significantly in recent months. 20

0 As discussed in Section 1, rising personal insolvencies may 1988 90 92 94 96 98 2000 02 04 reflect pockets of vulnerability within the household sector. At Sources: ONS and Bank calculations. the same time, some households may be undergoing a change (a) Households’ total financial liabilities excluding secured and unsecured debt (including bills that are due to be paid). in their attitudes towards personal bankruptcy. These 40 Financial Stability Report July 2006

developments may point to a small rise since December in the likelihood of household sector vulnerabilities crystallising (Table 3.A). On the other hand, as Section 2 discussed, banks have tightened lending criteria, unsecured lending growth has eased further and write-off rates on mortgage lending remain extremely low. Overall, these factors suggest that the potential impact of household sector vulnerabilities on UK banks is broadly unchanged since the December 2005 FSR.

The rising systemic importance of LCFIs. LCFIs play a pivotal role in the international financial system as intermediators of risk and as providers of liquidity to capital markets. As a result, the impact on global capital markets and the UK financial system of any stress to LCFIs’ balance sheets could be significant. This would be true whether LCFIs themselves were a source of disturbance or were a propagator of shocks elsewhere in the system.

As discussed in Section 2, LCFIs’ balance sheets have expanded rapidly over recent years, in part apparently reflecting increased risk taking. Buoyant financial market conditions and intense peer group competition may have helped spur these developments. While many firms may have believed that the price of some assets had become too high and the premia for taking risk too low, there are also risks in not expanding activities when others are doing so — for example, prime brokerage business with hedge funds and activity in structured finance markets. Firms’ ability to manage risk has improved markedly in recent years. But there are indications that the growing complexity of some financial instruments may sometimes outpace the capacity of the LCFIs or their counterparties to manage the associated risks — for example, in the area of settling and confirming credit derivative transactions. As noted in Section 2, this is an issue that the industry itself recognises and is tackling. UK banks’ counterparty links with LCFIs are also increasing.

Chart 3.7 LCFIs’ credit default swap premia(a) Taken together, higher risk taking and strengthening links to Basis points 110 the UK financial system suggest that the potential impact of 100 any stress at an LCFI on the UK financial system may have US securities houses 90 risen over the past six months (Table 3.A). The Bank’s 80 judgement is that the likelihood of severe distress at an LCFI is 70 US commercial banks very low and unchanged from six months ago. Their 60 profitability remains strong, they are highly capitalised and 50 they have well-diversified activities. The low likelihood of 40 severe distress at an LCFI is evident in the market’s assessment 30 of LCFI credit risk, as proxied by credit default swap (CDS) 20 European LCFIs premia, which remained low over the past six months 10 (Chart 3.7). 0 2002 03 04 05 06

Sources: Bloomberg, Markit and Bank calculations. Dependence of UK financial institutions on market

(a) Average premia weighted by total assets. infrastructures and utilities. Financial systems depend on the smooth functioning of financial market infrastructure. As Section 2 discussed, financial institutions in the United Kingdom rely particularly on Section 3 Prospects for the UK financial system 41

CHAPS, CLS, CREST and LCH.Clearnet Ltd for clearing and settling financial transactions. These systems are closely interlinked, so disruption to any one of them could have large and widespread implications. A particularly significant common dependency within the United Kingdom’s financial infrastructure is on the messaging services provided by SWIFT, which are used by most UK financial firms and wholesale market infrastructures. These dependencies underscore the importance of market infrastructure providers and the users of their services having effective contingency plans in place for the very unlikely event of an outage at a major infrastructure. As discussed in Section 4, further work is needed to put in place and test such plans.

As set out in the Bank’s Payment Systems Oversight Report 2005,(1) the UK payment systems remain robust when judged against international standards. And severe disruption to SWIFT messaging services is a remote possibility as there is extensive contingency planning at SWIFT, including multiple backup sites and systems. The likelihood of severe problems in market infrastructures and utilities is assessed to have not materially changed over the past six months (Table 3.A). The impact of any disruption is also judged not to have altered significantly over the period.

Overall, these vulnerabilities may have edged up slightly. Taken together, news on the key vulnerabilities since the December 2005 FSR, summarised in Table 3.A, suggests that a number have continued to build, albeit gradually. This has raised slightly their potential impact on the UK financial system in the very unlikely event that they should crystallise. Overall, the likelihood of disturbances triggering these vulnerabilities is little changed since December.

3.3 Prospects for the UK financial system

Stress tests provide a rough guide to the system’s resilience… To assess the resilience of the UK financial system, a judgement needs to be made not just on whether the vulnerabilities have increased or decreased, but on how serious they might be relative to the financial system’s buffers of profits and capital. This is extremely challenging and inevitably involves a substantial degree of subjective assessment. As a contribution to that judgement, the Bank has recently considered a number of hypothetical stress scenarios in which each of the key vulnerabilities is triggered and has assessed their effects on the UK financial system using a range of models. These stress-testing exercises are not a forecast of what is likely to happen to the UK financial system. Rather, they are a series of ‘what if?’ thought experiments to assess the resilience of the system to certain low probability,

(1) The Bank’s annual Payment Systems Oversight Report is available at www.bankofengland.co.uk/publications/psor/psor2005.pdf. 42 Financial Stability Report July 2006

but plausible, stress events. These stress tests, while hypothetical, are a useful starting point for understanding the channels of risk transmission that might operate in periods of significant strain and for gauging their likely importance. They can also be helpful in identifying risk mitigation work and in contingency planning for extreme events.

Box 6 explains the approach used, sets out the extreme stress scenarios considered and describes the channels through which the UK financial system could be affected. It also provides some preliminary, illustrative estimates of losses that might arise for the major UK banks in the unlikely event that these scenarios were to crystallise.(1) The various channels through which stress might affect financial institutions can be shown using a ‘risk transmission map’, which is illustrated in Box 7 by reference to the Russian debt default and the near-failure of Long-Term Capital Management (LTCM) in 1998. This illustration underscores the challenges faced in assessing in advance how crises might unfold and the importance of complementing analytical stress-testing work with market intelligence when forming an overall judgement on the importance of different vulnerabilities.

…with the impact of adverse events depending on how quickly they unfold... Banks’ ability to absorb stress depends importantly on the speed with which adverse events unfold. Some of the stress events described in Box 6 — such as those associated with household debt and corporate debt — may develop relatively gradually, giving time for banks to adjust, for example, by changing lending criteria or margins or by strengthening financial buffers. This would cushion the impact of these vulnerabilities if they crystallised.

The scenarios whose epicentre is located more directly within the financial sector — such as adjustments in risk pricing, LCFI stress and disruption to market infrastructure — may unfold more rapidly. In these cases, sharp falls in asset prices, uncertainty about market liquidity and about the responses of other market participants could amplify their impact. Current profits may not be available to absorb losses, so these events may have greater impact on banks’ capital. That in turn might also lead to increases in institutions’ funding costs in wholesale markets and higher collateral requirements in trading activities.

…but continuing resilience remains the most likely outcome… Far and away the most likely outcome in the near term is that none of the vulnerabilities crystallise. Even if these low probability tail events were to occur, preliminary results from the stress-test models, described in Box 6, suggest that

(1) These stress tests focus on possible losses that might arise for major UK banks, as an indication of the potential impact across the UK financial system. Section 3 Prospects for the UK financial system 43

Chart 3.8 Major UK banks’ credit default swap premia individually they would be unlikely to erode to any significant extent the capital base of the UK banking system. For Maximum-minimum range (a) Average Basis points example, in the unlikely event that one of the ‘slow burn’ stress 55 scenarios materialised, profits of the major UK banks would be (b) 50 likely to absorb losses. And losses in each of the ‘fast burn’ 45 severe stress scenarios would be unlikely to cause capital to 40 fall to levels that would raise serious concerns about the 35 viability of the system as a whole, though it is possible that the 30 reputation and financial standing of some UK institutions 25 could be affected. This relatively comforting picture is 20 consistent with continued low credit default swap premia for 15 major UK banks (Chart 3.8). 10

5 …though future risk-taking behaviour remains uncertain. 0 2002 03 04 05 06 The resilience of the UK financial system in the period ahead Sources: Bloomberg, Markit and Bank calculations. will depend on the future behaviour of investors and financial (a) Average CDS premia weighted by total assets. firms. Recent heightened market volatility has reminded (b) December 2005 FSR. investors and firms of the financial risks they are running. But it remains an open question whether it has resulted in a fundamental rethink of risk strategies. On the one hand, there is some evidence recently of greater caution about position-taking among some market participants, with the price of risk having increased. On the other, despite this recent increase, asset prices have not changed to any material extent from six months ago. Previous short-lived episodes of turbulence have, if anything, tended to reinforce perceptions about the stability of the system and have encouraged a return to the risk-seeking environment seen earlier. It is too early to assess whether that pattern will be repeated this time.

Vulnerabilities in combination could be more material… When gauging the future resilience of the UK financial system, it is also important to consider extreme scenarios, even though they are highly unlikely, in which severe shocks cause a number of vulnerabilities to crystallise in combination. Based on developments over the past six months, two such extreme scenarios appear plausible. First, a severe adverse supply-side shock — such as a sudden sharp reduction in the supply of oil, perhaps related to a marked escalation in geopolitical tensions Chart 3.9 Asset prices in the Middle East — could prompt a reassessment of the Index: Jan. 1998 = 100 300 global economic outlook and a sharper-than-expected turn in the global credit cycle. Second, asset prices have risen UK house price index 250 significantly in recent years (Chart 3.9). Problems might arise UK commercial property index if a sudden reversal in perceptions about risk resulted in a 200 substantial further fall in risky asset prices in both the Commodity (metals) MSCI world equity United Kingdom and overseas, at the same time as risk-free price index(a) 150 index(a) interest rates were rising sharply. These scenarios are discussed further in Box 6. 100

MSCI emerging markets 50 …with liquidity channels potentially amplifying these equity index(a) effects… 0 In severe scenarios, certain structural features of the 1998 99 2000 01 02 03 04 05 06 UK financial system, which have grown in importance in the Sources: Bloomberg, Halifax, Nationwide and Thomson Financial Datastream. recent past, could amplify market and credit risks. For (a) Latest data point based on an average of daily data in June 2006 up to the cut-off date of 26 June. example, demand for risky, and prospectively less liquid, 44 Financial Stability Report July 2006

instruments — including some tranches of structured credit products — has risen in recent years. This may increase the likelihood of a rapid unwind of positions in the event of losses which, owing to the potential illiquidity of the instruments, would then tend to amplify any downward price movements by more than has been the case in the past. This may be more likely if many investors are pursuing similar strategies, as perhaps was illustrated by adjustments in the prices of some of these assets during May and June. And in circumstances where fundamentals appear to have changed, hedge funds might also prove less willing or able to perform a stabilising role in markets than in the past.

On the liabilities side of the balance sheet, UK banks’ increased dependence on wholesale funding has heightened their sensitivity to liquidity developments. Increasing linkages within the UK financial system — for example, interbank and counterparty exposures between UK banks and LCFIs — could also amplify the transmission of risk at a system-wide level. These factors would tend to increase correlations between asset returns in a stress scenario, reducing some of the diversification benefits that appear to exist when correlations are low. Again, recent market developments perhaps illustrate such effects.

…highlighting the need for consideration of extreme stress scenarios in firms’ risk management. The severe crystallisation of credit, market and liquidity risk in combination could lead to a material erosion of UK banks’ capital, with potential knock-on effects to supporting markets, institutions and infrastructures. Illustrative calibrations of stylised severe supply-shock and asset price adjustment scenarios (discussed in Box 6) suggest that losses in either case could be substantial. These estimates are not forecasts for the UK financial system, as scenarios generating such effects are both extreme and highly unlikely. But given their implications, such scenarios merit careful consideration in financial firms’ risk management planning. Section 3 Prospects for the UK financial system 45

Box 6 Table 1 Summary of stress scenarios

Systemic stress testing Vulnerability Moderate stress Severe stress scenario scenario Stress testing provides a consistent framework for illustrating Low risk premia Risk premia return to their historic average… and measuring how remote tail events might affect financial correction …in an orderly way (eg …and rise further (eg high-yield institutions and the financial system as a whole.(1) This box high-yield corporate spreads corporate spreads increase describes how Bank staff are using stress-testing models as increase by about 100 basis by about 400 basis points an input to the Bank’s assessment of the resilience of the points to around 400 basis to around 700 basis points). points). UK financial system.(2) Global imbalances A combined shock to the US dollar, global long rates and US The stress-testing approach being developed has four steps: unwind GDP, such that the US current account deficit shrinks to… …4.5% of GDP over three years. …2% of GDP over three years. Annual US GDP growth falls to Annual US GDP growth falls Step 1. Identifying systemic vulnerabilities 1.5%; US dollar falls 15%; to 0.5%; US dollar falls 30%; First, vulnerabilities which could be sources of severe US long rates rise to about 7%. US long rates rise to about 8%. disruption to the UK financial system are identified. A list of Global corporate A combined supply shock to both the UK and overseas markets, potential vulnerabilities is described in the main text. stress leading to a macroeconomic slowdown and rising inflation… …UK GDP growth slows to …UK GDP growth falls to -1.5%, Step 2. Constructing stress scenarios 1%, house prices fall by around house prices fall by around 25% 10% and commercial property and commercial property prices The second step is to identify extreme but plausible stress prices by 20% over three years. by 35% over three years. scenarios in which each of the vulnerabilities crystallise. There Overseas countries experience Overseas countries experience a are many possible scenarios, varying in likelihood and impact. a shock of similar magnitude. shock of similar magnitude.

To shed light on the range of possible impacts, two UK household Same supply shock as in global corporate vulnerability (featuring hypothetical scenarios are examined for each of the stress macroeconomic slowdown and rising inflation), but affecting the vulnerabilities — one a moderate stress event, the other United Kingdom only. judged to represent more severe stress. The scenarios are LCFI stress Potential losses on a portfolio of large counterparty exposures to selected not because they are likely — they are generally very LCFIs with probabilities of default and correlations derived from low probability tail events — but because they provide an CDS premia… illustration of the scale of disturbance that might occur in …losses above 95th …losses above 95th percentile, percentile, based on recent based on CDS spreads in extreme cases. The stylised scenarios — summarised in CDS spreads. October 2002 and an adjustment Table 1 — are as follows: to correlation to simulate heightened systemic risk (i) A correction in low risk premia between LCFIs. These stress scenarios analyse a reversion of risk premia on Infrastructure Outage of SWIFT messaging services… equities and on high-yield, investment-grade and emerging disruption …for one day. …for two weeks. market bonds to their historical averages, either gradually in the moderate stress scenario, or rapidly with overshooting in supply shock, leading to lower global growth, higher interest the severe case. rates, falling commercial property prices and rising corporate (ii) An abrupt unwinding of global imbalances income gearing. In the moderate stress scenario, the UK corporate liquidation rate and the write-off rate on UK and The stylised scenarios consider an abrupt unwinding of global overseas corporate exposures double. In the severe stress imbalances of varying degrees of severity. In both scenarios, scenario, the UK corporate liquidation rate reaches its early the US dollar is assumed to depreciate significantly, US bond 1990s peak and the write-off rate on UK and overseas yields to rise and global growth to weaken. Adjustment in the exposures trebles. moderate stress scenario is relatively limited, with the US current account deficit falling to around 4.5% of GDP over three years; in the severe stress scenario, it shrinks sharply to (iv) A marked rise in UK household sector financial 2% of GDP. Credit spreads rise globally as credit quality distress declines and property and equity prices both fall. These stress scenarios embody a significant adverse supply shock that causes a sharp slowdown in UK growth and a (iii) A sharp fall in global corporate credit quality pickup in inflation. The scenarios involve falling UK house These stress scenarios consider the impact on corporate prices, rising household distress and increasing defaults and finances of a macroeconomic slowdown in the United write-off rates. The severe stress scenario is similar to the Kingdom and in overseas markets in which UK banks have 1990s UK recession, whereas the moderate scenario is less significant exposures. The scenarios involve a large adverse pronounced. 46 Financial Stability Report July 2006

(v) LCFI stress Chart A Risk transmission map The LCFI stress scenarios are based on losses arising on a portfolio of large counterparty exposures of UK banks to LCFIs. Financial shocks Real shocks The scenarios are defined by points on portfolio loss distributions. In the moderate stress scenario, UK banks are Manifestation assumed to incur expected portfolio losses above the Other financial Household 95th percentile. The loss distribution is defined by a mean institutions sector probability of LCFI default and a default correlation based Corporate Public on recent credit default swap spreads. In the severe stress Infrastructure sector sector scenario, the mean default probability is increased to levels implied by spreads in October 2002, while an upward Amplifiers adjustment is made to the assumed correlation to simulate Financial Asset heightened sensitivity of LCFIs to a common shock. activity prices

(vi) Disruption to SWIFT messaging services Impact on major UK banks As an illustrative scenario of the potential impact of a Income Credit generation Operational disruption in infrastructure, an outage to SWIFT messaging risk risk risk services is considered. Two specific case studies are examined Market Funding — a one-day outage and a two-week shutdown. Both risk risk scenarios are highly unlikely as these messaging services have never experienced a prolonged disruption and SWIFT has invested heavily in backup sites and systems to recover quickly Table 2 Channels explicitly quantified in stress scenarios(a) if problems arise. But they are selected because of their potential widespread impact on the UK financial system due to Low risk Global Global UK LCFI Market premia imbalances corporate household stress infrastructure dependencies on SWIFT. debt debt disruption

Step 3. Mapping transmission channels to banks Credit risk, exposures to: Shocks that trigger vulnerabilities can cause losses for major UK households GG G UK banks in a number of ways. These channels can be UK corporates GG G illustrated using a stylised ‘risk transmission map’ (Chart A). Overseas households GG Overseas corporates GG G Shocks may expose vulnerabilities in the balance sheets of Counterparty credit risk, financial and/or non-financial counterparties to UK banks — exposures to: domestically or overseas — leading to credit losses. Shocks LCFIs GG (or their impact on borrowers) may also lead to asset price Other financial institutions G falls, resulting in losses on trading or banking book exposures, Market risk in and an erosion of collateral values on secured exposures. trading book GG G Banks’ funding costs may rise and a weaker business Income generation risk GG GG G environment may lower financial activity and so reduce banks’ Funding risk GG GG G income. Operational risk G Macroeconomic feedback effects Banks may respond to an increase in credit write-offs, market Market liquidity losses or a decline in their income by adjusting their behaviour. disruption Although this may aim to mitigate individual bank losses, it (a) A circle denotes that a channel is quantified — fully or partially — in the stress scenario impact estimates. could amplify the system-wide impact. For example, a widespread tightening of credit terms might lead to refinancing difficulties, precipitating further credit losses. Or a modelling limitations; and some are not quantified at all. generalised fall in risk taking might reduce market liquidity, Table 2 shows which channels have been explicitly quantified amplifying asset prices falls. for each of the stress scenarios. The table illustrates that some channels (such as credit risk) can be quantified reasonably Step 4. Measuring risk transmission channels well, whereas others (including the financial market Quantifying the impact of stress scenarios on the UK financial amplification effects discussed in Box 5) may be captured system is very challenging. In each scenario some possible partially but are not explicitly estimated. These missing channels can be quantified using models; others only by channels, and the wide uncertainties, need to be borne in mind making assumptions and judgements because of data and when interpreting the results of these stress tests. Section 3 Prospects for the UK financial system 47

All impacts are calculated as losses to the major UK banks (v) Funding risk relative to base profit levels. The metric of UK bank losses is UK banks may face a reduction in the availability of funding intended to provide a gauge on the potential broader impact and an increase in its price in stressed circumstances. For on the UK financial system. Losses are calculated over a example, funding costs could rise if banks suffer downgrades in three-year horizon following the initial shock to give time for their credit ratings due to losses incurred. A simple approach is effects to feed through to banks’ balance sheets. used to capture these costs in the corporate, household, global imbalances and low risk premia stress scenarios. This is based (i) Credit risk on case studies of previous episodes when banks were Credit losses are estimated in the corporate, household, low downgraded and the effect this had on their funding costs. In risk premia and global imbalances scenarios using the several of the moderate stress scenarios, banks’ losses from stress-testing approach described by Bunn et al (2005).(3) The other channels are judged to be too low to trigger an increase Bank’s macro-forecasting model is used to simulate changes in in funding costs. the economy over a three-year horizon. This forecast is fed into a suite of models for household and corporate balance (vi) Operational risks sheets, which estimate effects on corporate liquidations and Operational risks are likely to be a key channel in any on household secured and unsecured arrears. These are then infrastructural disruption, including the SWIFT outage mapped into losses for UK banks, net of recovery through scenarios considered as a case study. In these scenarios, collateral. These models, being based on historical possible impacts on UK banks have been estimated using firms’ (5) relationships, will not capture structural changes in banks’ and responses to the FSA Resilience Benchmarking survey (2005) borrowers’ balance sheets. that included estimates of the costs, claims and charges likely to arise in the event of key wholesale market functions being (ii) Counterparty credit risk disabled. These figures also include a funding risk element. In the estimates shown, some allowance is made for additional A Basel II style advanced ‘internal rating-based’ (IRB) approach channels that could be activated, including counterparty credit is used to estimate counterparty losses for UK banks that risk on increased exposures to other banks and from possible might arise in the event that one or more LCFI encountered settlement delays. Estimates of trading risk from heightened serious problems. An aggregate portfolio of large exposures of market volatility are derived from banks’ VaR disclosures, and UK banks to LCFIs is constructed. The method uses default possible losses of income are based on data on banks’ dealing probabilities and correlations extracted from observed CDS profits. Uncertainties around the impact of a long outage prices to generate an estimate of the average ‘tail’ losses that include the possibility that daily costs may build up over time, UK banks could incur on this portfolio in the event of extreme perhaps as business delays mount, or may diminish as LCFI stress. These estimates are sensitive to different workarounds are found. assumptions about exposure levels, average default probabilities, default correlation and loss given default. (vii) Other channels A number of other channels that may be important in times of (iii) Market risk stress — particularly for some vulnerability scenarios — are not Falls in asset prices can generate marked-to-market losses on quantified fully or in some cases at all. These include sharp banks’ trading books. In the low risk premia and global falls in market liquidity or disrupted market functioning, as imbalances scenarios, proxy estimates of trading book well as possible feedback effects between the financial system exposures to asset price changes are derived using and the macroeconomy. For expositional purposes, banks are Value-at-Risk (VaR) disclosures and the volatility of the assumed not to respond to the shock scenarios by adjusting underlying assets. Losses are then estimated by applying asset their balance sheets, pricing or other behaviour. It is also price falls to the exposures for different asset classes. These assumed that monetary policy follows a mechanical estimates are imperfect measures of exposure to market risk, Taylor rule at all times.(6) These assumptions generate an since the VaR data do not indicate whether a bank is long or additional source of uncertainty around the impact estimates, short in an asset. Market risk in the trading book is therefore on top of uncertainties around the channels that are quantified (4) imperfectly captured. in the scenarios.

(iv) Income generation risk Quantifying impact in vulnerability scenarios Net interest is the UK banks’ largest single source of income Chart B shows some preliminary, illustrative estimates of the and may fall in a weaker economic environment. This effect is potential losses — relative to base profit levels — that could captured using an estimated equation that relates net interest arise for the major UK banks over a three-year horizon in each income to real GDP growth (see Bunn et al (2005)). Estimates of the moderate stress scenarios. Chart C reports results for are also made of potential falls in other sources of banks’ the severe stress scenarios. The reported losses are scaled by income, such as fees. the Tier 1 capital of the major UK banks although, importantly 48 Financial Stability Report July 2006

Chart B Impact and likelihood of ‘moderate stress Chart C Impact and likelihood of ‘severe stress scenarios’ affecting vulnerabilities(a) scenarios’ affecting vulnerabilities(a)

Impact as a percentage of Tier 1 capital(b) Impact as a percentage of Tier 1 capital(b) 10% 20% 30% 40% 50% 10% 20% 30% 40% 50%

Low

Low Low risk premia Low risk premia

Global imbalances Slight Global corporate debt

Global corporate debt UK household debt Probability: Probability: Slight UK household debt Global imbalances

LCFI stress Remote LCFI stress

Remote Market infrastructure disruption Market infrastructure disruption

Source: Bank calculations. Source: Bank calculations.

(a) Central band shows best current quantified estimate of scale of loss under each scenario; (a) Central band shows best current quantified estimate of scale of loss under each scenario; wider bands include allowances for some uncertainties around these calibrations. A number wider bands include allowances for some uncertainties around these calibrations. A number of potential channels are not included in the bands. of potential channels are not included in the bands. (b) Total impact for major UK banks of individual scenarios over a three-year horizon, relative to (b) Total impact for major UK banks of individual scenarios over a three-year horizon, relative to base. The impact is expressed as a percentage of current Tier 1 capital but, given UK banks’ base. The impact is expressed as a percentage of current Tier 1 capital but, given UK banks’ current profits, does not necessarily imply a loss of capital. current profits, does not necessarily imply a loss of capital. given the additional buffer provided by banks’ current profits, An abrupt unwinding of global imbalances is unlikely. But that does not imply that capital would necessarily be eroded. Bank staff calibrations suggest it could generate significant Central estimates of these losses are indicated by darker losses for major UK banks, with rough calibrations equivalent bands, with the lighter bands making some allowance for the to 15%–35% of UK banks’ Tier 1 capital in a remote severe uncertainties around these calibrations. The potential for stress scenario. other impacts from currently unquantified channels, which may lead to additional losses or may mitigate the impact, is Estimated losses for UK banks in a scenario where global indicated by the arrows. The impact estimates are partial and corporate credit quality falls sharply are also material — in the uncertain, so are not strictly comparable across the extreme, but unlikely, severe stress scenario they are vulnerability scenarios. And the time profile of losses is equivalent to 15%–30% of Tier 1 capital. Write-offs on likely to vary across scenarios, as discussed in the main domestic and overseas credit exposures account for the bulk of text. these losses. Uncertainties around the estimates are substantial, however, not least given the paucity of data on the The charts also show a preliminary judgement on the scale of UK banks’ overseas corporate exposures. likelihood of these alternative scenarios, with each vulnerability scenario placed in one of three probability ranges Estimated losses arising from the UK household sector stress — low, slight and remote. The likelihood of any specific scenario are relatively small, except in the unlikely event of a scenario occurring is close to zero. So the probabilities are severe macroeconomic downturn. In the severe stress broad judgements on the chance of a comparable event scenario, estimated losses are equivalent to 10%–20% of Tier 1 occurring. Most of the moderate stress scenarios are judged to capital. Because they are based on historical relationships, be slight possibilities, while a number of the severe stress these calibrations take no account of any potential recent scenarios are judged to be remote. structural change in households’ or banks’ behaviour.

Taking each of the vulnerabilities in turn, the likelihood of a Severe stress at one or more LCFIs is unlikely, but could have a moderate correction in risk premia is judged to be greater than significant impact on major UK banks. It is impossible to for the other vulnerabilities, but the estimated impact is quantify the impact with any precision. Relevant factors relatively modest. Losses in a more severe scenario, involving would include which LCFI (or LCFIs) was in difficulty, the some overshooting of risk premia, are more material. underlying cause of the distress, the timing and speed with Calibrated losses are equivalent to some 5%–15% of which problems unfolded and the exposures and activities UK banks’ Tier 1 capital. Several potentially important affected. The responses of other market participants would be channels of impact — such as losses on counterparty credit critical. The estimates of losses in a remote scenario that exposures and potential market liquidity disruption — are not involves severe stress across a number of LCFIs are equivalent fully captured by these calibrations. to 10%–30% of Tier 1 capital. These are estimates of the Section 3 Prospects for the UK financial system 49

losses to UK banks that might arise from direct counterparty net interest income. As a result of these losses, banks’ exposures to LCFIs in distress. Several other potential creditworthiness falls and their funding costs rise. transmission channels — for example, arising from wider credit losses, asset prices falls and financial market disruption — are (ii) Sharp, widespread rises in global interest rates and not fully captured by these calibrations. risk premia This scenario involves a sharp increase in long-term interest As an illustration of the potential impact of disruption to rates and risk premia in the United Kingdom, the United States market infrastructure, scenarios are considered in which there and the euro area. Output growth falls alongside asset prices. are outages of SWIFT messaging services. These scenarios are So, for example, nominal UK long rates are modelled to all very remote possibilities. The best estimate of losses is increase by around 150 basis points, the spread on high-yield quite modest, but there is considerable upside uncertainty corporate bonds rises by around 500 basis points and UK GDP about impact. These uncertainties mean that calibrated losses falls by about 2% relative to base. These developments trigger could be equivalent to up to 15% of Tier 1 capital, even though a number of the vulnerabilities, particularly the low risk the central estimate is much lower. These estimates do not premia, household and corporate debt vulnerabilities. Losses include wider losses to the UK financial system — for example, crystallise through a range of channels, including trading through potential market dislocation. losses, rises in credit write-offs on corporate and household exposures, higher funding costs and income losses. Generalised stress scenarios In practice, one or more of the key vulnerabilities could be Illustrative calibrations of these broad severe stress scenarios exposed simultaneously (if triggered by a common shock) or suggest that losses in either case could be equivalent to sequentially (if one vulnerability knocks onto another). around 30%–40% of major UK banks’ Tier 1 capital. Conducting stress tests for generalised stress scenarios involves the same steps and the same types of uncertainty Limitations of the stress-testing approach described for the individual vulnerabilities. But some of the Modelling the impact of stress scenarios on banks is complex. simplifying assumptions about the absence of behavioural There are many uncertainties around the quantitative results. changes are likely to be more questionable in these broader Some derive from using models based on historical scenarios, given their potentially greater impact. Nonetheless, relationships, which may have changed or may not hold in stress scenarios that involve shocks affecting several stress events. Others reflect simplifying assumptions about vulnerabilities simultaneously provide some guide to the the behaviour of borrowers, banks and policymakers. Potential potential impact of such events. Two such scenarios are feedbacks through asset markets or changes in banks’ lending considered: behaviour, which may be substantial, are not modelled explicitly at present. Data availability is also a significant (i) A large adverse supply-side shock problem when quantifying some of the channels in the This stress scenario is a stylised severe adverse supply-side transmission map. shock to the global economy, which results in a broad-based slowdown in real activity and higher inflation and interest The model-based estimates presented in this Report are rates. The stress scenario represents a global economic illustrative of the approach that the Bank is developing to slowdown that is calibrated to resemble, in terms of severity, assess quantitatively the relative importance of different the early 1990s UK recession. The channels through which the vulnerabilities in the UK financial system, but they are global shock propagates are common to the global corporate preliminary and partial. The value of these stress tests is in and household vulnerability scenarios and are quantified using providing a consistent framework for understanding risks and the same approach as described in Step 4. The severe identifying key questions and vulnerabilities requiring further recession triggers losses for UK banks as write-off rates on analysis. As such, at present they represent one contribution household and corporate debt rise in the United Kingdom and to the Bank’s overall judgement on prospects for financial overseas. The slowdown in economic activity reduces banks’ stability.

(1) Section 4 discusses the key role that stress testing plays in risk management at individual institutions. (2) The Bank plans to publish a fuller account of this stress-testing approach later this year. (3) Bunn, P, Cunningham, A and Drehmann, M (2005), ‘Stress testing as a tool for assessing systemic risks’, Bank of England Financial Stability Review, June, pages 116–26. (4) With the exception of the trading book, the impact of stress scenarios on the overall economic value of banks is not measured. (5) FSA (2005), Resilience Benchmarking Project Discussion Paper, December. (6) Under the Taylor rule, the level of interest rates depends on the rate of inflation relative to its target and the level of output relative to trend. 50 Financial Stability Report July 2006

Box 7 so.(3) Margin calls from creditors forced highly leveraged institutions to sell assets (line 5). Risk transmission in the Russian and LTCM crises Internal margin calls were also made on the proprietary desks of investment banks. That increased market price volatility and led to automatic selling by investors, many of whom were The risk assessment approach used by the Bank in this Report using the same trading models and were investing in similar can be illustrated by reference to the Russian and Long-Term assets. This accentuated falls in asset prices (line 6). Capital Management (LTCM) crises in 1998. Figure A shows the key propagation channels during this crisis. The initial Market turbulence heightened in early September on rumours shock was the Russian authorities’ decision in mid-August that LTCM was facing insolvency and that other institutions 1998 unilaterally to restructure their domestic currency (including some of LTCM’s major creditors and counterparties) government debt (line 1 in Figure A). The default led to a might be in a similar position (line 7).(4) The crisis culminated currency crisis — the rouble fell by more than 60% in August in late September with the Federal Reserve Bank of New York — and a banking crisis as Russian banks made heavy losses on facilitating discussions among LTCM’s major creditors, holdings of government bonds, while simultaneously their net counterparties and investors, which led to a $3.6 billion private (1) foreign currency liabilities increased significantly. sector rescue of LTCM. There were two systemic concerns about an immediate closure of LTCM. First, it might have The crisis had a large impact on global financial stability impaired the already fragile financial position of some of despite the quite limited direct exposures of international LTCM’s creditors and counterparties (line 8). Second, and banks to Russia (line 2).(2) Exposures of BIS banks as a whole more importantly, it might have weakened LCFIs not directly were only about 3% of their total foreign claims. Instead, the involved with LTCM due to falls in asset prices following the default was propagated to international banks mainly fire sale of LTCM’s assets by its creditors (lines 9 to 11). indirectly through its impact on global capital markets. The crisis led to a generalised reassessment of credit risk in This illustration highlights the need to consider a wide range of emerging and mature markets. This resulted in a flight to possible crisis propagation channels. In addition, while data quality — while spreads and yields on risky debt increased transparency of major financial institutions has improved in sharply, yields on US Treasury bonds fell (line 3). The second recent years, the growing role of new participants and the indirect channel was the reaction of international banks and growth in complex new instruments mean that data-driven other large financial institutions (line 4). Some firms chose to risk analysis needs to be complemented by market reduce riskier asset positions while others were forced to do intelligence.

Figure A Risk transmission map: Russian default (August) and LTCM near-failure (September 1998) Shocks Manifestation Impact on Channels: Russia Propagation/amplifiers international banks 1 Russian government’s default on its domestic currency debt. 2 Impact on the direct exposures of international banks and other LCFIs to the Russian government, corporates and banks. (1) Public 3 Reassessment of credit risk in other emerging markets and mature credit markets. 4 Losses to international banks and other LCFIs on their market exposures. Real shocks Household Banks (2) 5 Forced or voluntary selling of assets by LCFIs. Credit risk 6 Impact of asset sales on asset prices. 7 LTCM close to default. (8) 8 LTCM’s failure thought to result in big losses Corporate (3) for its creditors and counterparties. Market risk 9 Large sell-off of LTCM’s assets and correspondingly (4) the same assets held by other financial institutions. 10– Anticipated impact of LTCM’s asset sales on (2) Asset prices 11 asset prices and thus on the market risk of (11) Income generation risk financial institutions. (6) (5) (4) (Dotted lines 8–11 reflect the channels that the (10) organised bail out of LTCM sought to avoid.) (11) Funding risk Other financial (5) Financial activity institutions (7) Financial shocks Operational risk (8) (9)

International non-bank financial sectors

(1) See De Paoli, B, Hoggarth, G and Saporta, V (2006), ‘Costs of sovereign default’, Bank of England Financial Stability Paper no. 1, on the broader costs of sovereign crises, available at www.bankofengland.co.uk/publications/fsr/fs_paper01.pdf. (2) Some other financial institutions had larger concentrations of exposures. (3) Indeed, Salomon Smith Barney’s earlier decision to close its US bond arbitrage operation is an example of how dealer exit can materially affect less liquid markets. (4) By early September LTCM had used half of its capital on margin calls, mainly on its exposures to mature markets. Section 4 Mitigating risks to the UK financial system 51

4 Mitigating risks to the UK financial system

Private sector risk management has improved significantly over the past decade as a result of a sequence of private and public sector initiatives. The Bank’s assessment indicates a number of areas where management of risks to the financial system may need further attention, in particular: liquidity risk; aggregate economic and financial risk; risk aggregation within and across firms; and contingency planning. This section discusses work that is under way and new work that might need to be undertaken by the private sector and the public authorities to address these gaps.

Table 4.A Recent initiatives to improve financial sector risk Responsibility for mitigating risks to the UK financial system is management(a) shared between the private sector and the public authorities — HM Treasury (HMT), the Financial Services Authority (FSA) and Led by: the Bank of England. Over recent years, a sequence of Private sector Official sector initiatives has resulted in significant improvements to risk

Completion of Basel II framework(b) G management practices within the private sector. Table 4.A Counterparty Risk Management Policy Group II report(c) G presents a summary of some recent initiatives. Bank of England Money Market Reform(d) G Stress-testing initiatives(e) G G New framework for IMF surveillance(f) G The revision of the Basel capital accord — Basel II — has been Revision of HMT/FSA/Bank MoU(g) G led by the official sector, but has involved an intensive Financial crisis management processes(h) G programme of work for both the public and private sectors (i) G G Business continuity exercises over the past decade.(1) The Basel II framework has been OTC derivatives post-trade processing initiatives(j) G G agreed and implementation in the European Union is planned Source: Bank of England. to start in 2007–08. Preparation for the new bank capital (a) Initiatives completed in the past year or ongoing. (b) www.bis.org/publ/bcbs118.htm. standards has itself helped promote best practice in modelling (c) www.crmpolicygroup.org/docs/CRMPG-II.pdf. (d) www.bankofengland.co.uk/markets/moneymarketreform/index.htm. and measuring credit risk, both within the private sector and (e) www.fsa.gov.uk/pubs/discussion/dp05_02.pdf and www.crmpolicygroup.org/docs/CRMPG-II.pdf. (2) (f) www.imf.org/external/np/pp/eng/2006/040506.pdf and among supervisory agencies. On the private sector side, the www.imf.org/external/np/sec/pr/2006/pr0681.htm. (g) www.bankofengland.co.uk/financialstability/mou.pdf. second report of the Counterparty Risk Management Policy (h) www.bankofengland.co.uk/publications/other/financialstability/briefing_051209.pdf. (3) (i) www.fsc.gov.uk. Group (CRMPG) was published in July 2005, following up (j) www.newyorkfed.org/newsevents/news/markets/2005/an050915.html, www.newyorkfed.org/newsevents/news/markets/2006/an060216.html and their earlier report in 1999. This established a set of detailed www.bis.org/press/p060213b.htm. These initiatives are discussed in Section 2. recommendations and guiding principles for improving risk management and monitoring in the private sector. It highlighted a number of priority areas, including back-office problems in over-the-counter (OTC) derivatives markets,

(1) Basel Committee on Banking Supervision (2005), ‘International convergence of capital measurement and capital standards: a revised framework’, November. Available at www.bis.org/publ/bcbs118.htm. (2) See Schmidt Bies, S (2006), ‘A risk-management perspective on recent regulatory proposals’, 10 April. Available at www.bis.org/review/r060419d.pdf. (3) ‘Toward greater financial stability: a private sector perspective’. Available at www.crmpolicygroup.org/. 52 Financial Stability Report July 2006

particularly for credit products (discussed in Section 2). Subsequent credit events have underlined a number of the issues raised in the report, such as the methodologies to be applied in the settlement of contractual obligations.

Despite clear examples of progress, the Bank’s assessment points to a number of areas where risk management and planning might usefully be improved further. These can be divided into four categories:

• liquidity risk; • aggregate economic and financial risk; • risk aggregation within and across firms; and • contingency planning.

4.1 Managing liquidity risk

Understanding, modelling and hence pricing liquidity risk is more difficult — and as a result less advanced — than for, say, market and credit risk because of the complexity and unpredictability of the interactions which may arise. As highlighted in Section 2 of this Report, two structural developments suggest that liquidity risk is becoming relatively more important over time to financial intermediaries and so to the UK financial system as a whole. First, the build-up in exposures of some financial counterparties to more complex, and in some cases less liquid, instruments — affecting so-called market liquidity risk. Second, the increasing reliance by UK banks on wholesale funding — raising so-called funding liquidity risk.

Bank of England sterling money market operations have been reformed… From the official sector side, several initiatives have been undertaken or are under way which would help mitigate these risks. In the United Kingdom, fundamental reforms to the Bank’s operations in the sterling money markets were introduced on 18 May.(1) These reforms have increased the number of counterparties able to access sterling liquidity directly from the Bank, from around 20 prior to the reforms to over 50 afterwards. The system allows members to vary their balances at the Bank from day to day, provided that they meet their average target over the periods between the MPC’s monthly interest rate decisions and that balances remain positive at the end of each day. This should provide the banking system with greater flexibility in the day-to-day management of liquidity. In addition, the vast majority of the UK banking system — accounting for 95% of eligible liabilities(2) — is now able to borrow directly from, or deposit

(1) See ‘The framework for the Bank of England’s operations in the sterling money markets’, (the ‘Red Book’), May 2006. Available at www.bankofengland.co.uk/publications/news/2006/055.htm. See also ‘A banking system worthy of the City’s markets’, Paul Tucker, Financial Times, 15 May 2006. (2) Sterling eligible liabilities broadly comprise sterling deposits (deducting deposits placed with other banks and building societies). Section 4 Mitigating risks to the UK financial system 53

money with, the Bank through standing facilities, in unlimited amounts against eligible collateral on the borrowing side Chart 4.1 Access to the Bank’s facilities(a) (Chart 4.1). This should lessen the risk of liquidity bottlenecks arising within the private sector, which are more prevalent in Standing facilities times of market stress. participants(b)

Reserve scheme In the event of major operational or financial disruption to the members(c) sterling money markets or their supporting infrastructure, the Settlement banks(d) OMO money markets may effectively be closed. In those counterparties(e) circumstances, the Bank would be able to narrow the spread 65 between the lending and deposit facility around the Bank rate, 90 if necessary to zero, to facilitate the provision of liquidity to the market. 95 These reforms have also had the side-effect of encouraging a greater number of UK-operating banks to join the UK Source: Bank of England. high-value payment system, CHAPS. Abbey joined in (a) Per cent of eligible banking system liabilities covered by participating firms, as at the time of launch of sterling money market reforms. Eligible liabilities broadly comprise sterling November 2005, UBS has announced plans to do so next year deposits, deducting deposits placed with other banks and building societies. (b) Can have access to standing facilities only. and several others are considering the case. Increased (c) All must have access to standing facilities. (d) Automatically reserve participants. membership of CHAPS reduces intraday unsecured (e) Can be an open market operations (OMO) counterparty only. Open to non-cash ratio deposit-paying banks, building societies and securities dealers that are active intermediaries interbank credit exposures in the system, and the associated in the sterling markets. Under the Cash Ratio Deposit (CRD) scheme, certain institutions authorised to accept deposits under the Financial Services and Markets Act 2000 (banks and risks.(1) building societies) are obliged under Schedule 2 of the Bank of England Act 1998 to place non-interest bearing deposits (CRDs) with the Bank of England. This sequence of reforms is intended to introduce greater resilience to sterling markets and institutions, by encouraging prudent liquidity management by participants in normal conditions together with greater flexibility of liquidity provision and management during periods of stress.

…alongside initiatives to improve liquidity management internationally… In parallel with these domestic initiatives, work is under way internationally on liquidity management issues. The Bank participated, alongside the FSA, in the recently published study of liquidity risk management in financial groups conducted by the Joint Forum.(2) This study highlighted that, in a crisis, most banks would seek to manage liquidity on a more centralised basis than in normal market conditions. That would involve moving funds across borders and/or between affiliates.

In that regard, a parallel study by the G10 Committee on Payment and Settlement Systems(3) (CPSS), in which the Bank also participated, examined whether arrangements to facilitate the cross-border movement of collateral used to back central bank credit provision were adequate. The study found that, while no new infrastructure would necessarily be required, increased co-ordination between central banks would improve the effectiveness of existing arrangements.(4) The CPSS report

(1) See the Bank of England Financial Stability Review, December 2005: Themes and Issues. Available at www.bankofengland.co.uk/publications/fsr/index.htm. (2) The Joint Forum is an international group of supervisors of firms in the banking, securities and insurance sectors. See www.bis.org/publ/joint16.pdf. (3) Cross-border collateral arrangements, January 2006. Available at www.bis.org/publ/cpss71.htm. (4) The liquidity risk implications of increased cross-border collateral use are explained in Manning, M and Willison, M (2006), ‘Modelling the cross-border use of collateral in payment systems’, Bank of England Working Paper no. 286. 54 Financial Stability Report July 2006

also encouraged central banks to consider expanding their eligible collateral lists to include a wider range of foreign Table 4.B Existing cross-border collateral linkages(a) securities, at least in times of stress. For instance, the Bank of England routinely accepts euro-denominated securities and No arrangements to accept cross-border collateral will also accept US Treasuries in exceptional circumstances Collateral accepted in emergency only Collateral accepted routinely (Table 4.B).

In addition to improving central banks’ management of liquidity and collateral, further analysis is warranted on the Collateral case for improving liquidity standards. Existing national accepted by: Collateral denominated in: Canadian dollar Euro Yen Swedish krona Swiss franc Sterling US dollar standards may need to be reappraised in the light of structural Canada developments, such as increased use of foreign currency Euro area(b) Japan funding and off balance sheet products. More fundamentally, Sweden(c) given the increasingly cross-border nature of financial activity, Switzerland it may make sense to seek a greater degree of consistency in United Kingdom(d) (1) United States(e) the objectives of liquidity standards across jurisdictions.

Source: BIS, Committee on Payment and Settlement Systems, Cross-border collateral arrangements, January 2006. …with liquidity stress testing by firms a priority.

(a) This table maps the use of collateral denominated in the currencies in the columns (collateral denominated Alongside these official sector initiatives, there is clearly in:) to secure central bank lending in economies in the rows (collateral accepted by:). (b) There is also extensive cross-border use of collateral within the euro system, but with only further scope for improving private sector financial firms’ euro-denominated securities eligible. (c) The Swedish Riksbank also accepts Danish and Norwegian krona cash, using the Scandinavian cash pool. testing of liquidity risk.(2) On the funding side, for example, (d) The Bank of England accepts US Treasury bonds only in exceptional circumstances (see The Framework for the Bank of England’s Operations in the Sterling Money Markets, page 24, Contingencies). the Joint Forum found that only one third of surveyed banks (e) Refers to collateral backing Discount Window lending. test the impact of a firm-specific event — such as a ratings downgrade — within an unsettled market environment, with some two thirds simulating the two separately. On the market liquidity side, given the growing importance of complex and structured products whose liquidity characteristics in stressed market conditions are uncertain, stress testing may need to be given greater priority by financial firms and regulatory agencies in the period ahead. Those stress tests could usefully include the impact on liquidity risk of dealer exit from key markets under stressed conditions.

4.2 Managing aggregate risk

As Section 1 discussed, there are indications that perceptions of aggregate economic and financial risk may have increased in recent months. That highlights the importance of stress testing to assess the impact of plausible but severe macroeconomic events on banks’ balance sheets.

Firm-level stress testing of severe economic scenarios should be assessed… In recent years, UK and other firms have improved the testing of their resilience against different stress scenarios as part of their Basel II preparations. It is important that the scope and methods used meet three tests.

First, it is important that the chosen stress scenarios do not overly extrapolate from the macroeconomic stability

(1) Large, A (2005), ‘Financial stability: managing liquidity risk in a global system’, Bank of England Financial Stability Review, December. Available at www.bankofengland.co.uk/publications/fsr/2005/fsrfull0512.pdf. (2) See, for example, ‘Stress testing’, FSA Discussion Paper no. 05/2. Available at www.fsa.gov.uk/pubs/discussion/dp05_02.pdf. Section 4 Mitigating risks to the UK financial system 55

experienced in the United Kingdom and globally over the past ten years.(1) Second, these scenarios need to be internally consistent in terms of how macroeconomic variables behave and interact. Third, it is important that the results of these stress tests are both seen and acted on by firms’ senior management. Stress testing should contribute importantly to the setting of firms’ risk appetite.

The FSA is currently undertaking a survey of UK firms’ stress-testing practices as part of a campaign to identify good practice in the industry. The Bank believes there could, in due course, be some value in using a common set of scenarios as inputs to firms’ risk models, in addition to those particular scenarios that firms should individually consider given their exposures. That would facilitate cross-firm comparability of risk profiles. More generally, the publication of firms’ stress-test results might be a useful tool for enhancing market transparency and discipline.

…and the prospective ‘procyclicality’ of Basel II monitored… There is a related, but distinct, dimension to aggregate risk arising from the prospective introduction of Basel II capital requirements. Were these to bite, they might exacerbate a cyclical downturn by amplifying the contraction in credit. Quantitative work has been undertaken to gauge the potential scale of the ‘cyclicality’ of Basel II capital requirements and suggests it may be significant.(2) It will be important to closely monitor this effect once Basel II is in operation, as recognised by the Basel Committee.

…though multilateral surveillance and consultation on global economic risks may help reduce risk over time. At the IMF's spring meetings in April, G7 Ministers and Governors and the IMF's International Monetary and Financial Committee (IMFC) agreed that the IMF’s surveillance of the global economy should be strengthened.(3) The IMFC identified a number of reforms that could support this objective, including greater focus on multilateral issues in its surveillance and the development of new procedures to facilitate multilateral consultations about particular risks facing the global economy. These will begin with a focus on the orderly unwinding of global imbalances.(4) These reforms could, over time, lead to policies that reduce aggregate risk in the international financial system.

4.3 Managing aggregation risk

There are two dimensions to this risk — interdependencies between risks on individual firms’ balance sheets and

(1) See also the Governor’s speech at the CBI North East Annual Dinner, 11 October 2005. Available at www.bankofengland.co.uk/publications/speeches/2005/speech256.pdf. (2) Kashyap, A and Stein, J (2004), ‘Cyclical implications of Basel II capital standards’, Economic Perspectives, Q1, pages 18–31, Federal Reserve Bank of Chicago. See also Nier, E and Zicchino, L (2005), ‘Bank weakness and bank loan supply’, Bank of England Financial Stability Review, December, pages 85–93. (3) See www.imf.org/external/np/sec/pr/2006/pr0681.htm. (4) See www.imf.org/external/np/sec/pr/2006/pr06118.htm. 56 Financial Stability Report July 2006

interdependencies between firms themselves which might give rise to unforeseen risks for the system as a whole. There are challenges to risk aggregation and management in both dimensions. As Sections 1 and 2 highlighted, financial innovation and integration has tended to increase the scale of both risks recently.

Aggregating across risks on firms’ balance sheets… From a risk management perspective, there is clearly a need to look at balance sheet risks in an integrated fashion. That is easier said than done. As discussed in Section 3, credit, market and liquidity risk may become highly interdependent during periods of severe market stress.(1) And surveys have highlighted integrated stress testing as a key challenge.(2) Measuring linkages between risk types, in both normal and stressed situations, should be an important ingredient of firms’ testing and is clearly a priority area for further work by firms and supervisory agencies. For firms, that could usefully include a consideration of whether, in stressed circumstances, risks previously thought to have been distributed off balance sheet might return to them due to the terms of the financial contract. One example of this is where banks have sold illiquid instruments to, and provided finance for, hedge funds who are subsequently forced to sell back the asset because of a fall in its value, or to return it in the event of default as realised collateral.

…and aggregating across firms within the system. If anything, the gap in understanding and managing cross-firm interdependencies, and their implications for systemic risk, is even larger. A first line of defence against such risks is effective counterparty risk management by firms. Reports by the Bank for International Settlements, and more recently the CRMPG, provide a good road-map of best practices in this field.(3) One recommendation made by the latter report was that credit providers obtain adequate information from counterparties on contingencies that might affect their credit quality.

In the area of stress testing, firms could usefully give consideration to the likely response of other financial intermediaries. Firm-level practices are, however, unlikely to insure the system as a whole effectively given that, individually, firms may lack the incentives or tools to factor system-wide risks fully into their stress testing. Cross-system simulations and tests are needed to gauge fully system-wide risks.

(1) See also Drehmann, M, Sorensen, S and Stringa, M (2006), ‘Integrating credit and interest rate risk: a theoretical framework and an application to banks’ balance sheets’. Available at www.bis.org/bcbs/events/rtf06rmregcfp.htm. (2) Committee on the Global Financial System (2005), ‘Stress testing at major financial institutions: survey results and practice’, January. Available at www.bis.org/publ/cgfs24.htm. See also www.fsa.gov.uk/pubs/discussion/dp05_02.pdf. (3) See www.bis.org/publ/joint13.pdf, www.bis.org/publ/bcbs46.htm and www.crmpolicygroup.org/. Section 4 Mitigating risks to the UK financial system 57

Some simulations have been undertaken at the Bank, calibrated to UK data, in an attempt to assess these risks.(1) But there is considerable scope for refining and updating these simulations, as risks are likely to change as new sources of interdependence arise — for example, from the rapid growth of credit derivatives. The Bank is looking to develop a suite of models to understand and quantify these interdependencies better.

4.4 Contingency planning

Two of the key vulnerabilities identified in Section 3 arise from the adverse consequences of an individual stress event within the financial system — either at a market infrastructure or a large complex financial institution. Given the potential impact on the UK financial system, actions to limit the impact of either such event are clearly important for both the public authorities and the private sector.

UK contingency plans for managing a financial crisis… Recently, the UK authorities have put significant effort into re-examining and improving their processes for managing a financial crisis, deriving either from a financial event or from operational disruption affecting business continuity. Box 8 describes how risk assessment work may help inform such financial crisis management planning.

One aspect is how each UK authority discharges its responsibilities and how co-ordination between the three authorities takes place during a crisis. New procedures have been agreed over the past year and are reflected in a revised MoU.(2) These procedures have been informed by tests and discussion over the past couple of years, including studies of past crises such as the failure of Barings in 1995. Another UK official-sector financial crisis management exercise is likely to take place during 2007, to test and improve those processes further.

Managing the impact of the failure of a major global financial institution would require significant cross-border co-ordination. Recent initiatives to develop crisis-specific co-ordination networks include a MoU among EU central banks, regulators and finance ministries.(3) Later this year, the UK authorities and the Financial Stability Forum will jointly host a workshop for national authorities to share experiences in planning for both financial crises and business continuity incidents, focusing on cross-border communication issues. It

(1) Wells, S (2002), ‘UK interbank exposures: systemic risk implications’, Bank of England Financial Stability Review, December, pages 175–82. See also Elsinger, H, Lehar, A, and Summer, M (2006), ‘Using market information for banking system risk assessment’, International Journal of Central Banking, Vol. 2, No. 1, pages 137–65. (2) See the Memorandum of Understanding between HM Treasury, the Bank of England and the Financial Services Authority, March 2006. Available at www.bankofengland.co.uk/financialstability/mou.pdf. More detail on the crisis management framework may be found at www.bankofengland.co.uk/publications/other/financialstability/briefing_051209.pdf. (3) See www.ecb.int/press/pr/date/2005/html/pr050518_1.en.html. 58 Financial Stability Report July 2006

Box 8 experience suggests that wholesale funding — on which Risk assessment and crisis management UK banks increasingly rely — can be withdrawn quickly and unpredictably, as in the case of the 1984 run on No two financial crises are the same. As a result, the Continental Illinois Bank, which was almost entirely preparations which central banks and other authorities wholesale funded. Continental’s vulnerability built up make for managing a crisis — co-ordinated in the gradually. After loan quality problems emerged in 1982, United Kingdom by the Tripartite Standing Committee the bank’s access to domestic money markets became comprising the Bank, the Financial Services Authority and limited, forcing it to rely on foreign funding. In HM Treasury — need to be flexible. May 1984, rumours that Continental faced bankruptcy prompted the rapid withdrawal of much of this — as well These preparations are underpinned by regular as remaining domestic interbank deposits — in the ten assessments of vulnerabilities in the UK financial system. days before the US authorities announced a blanket These inform work on the UK and international crisis guarantee of the bank’s deposits. management frameworks and on ex-ante information gathering. They also develop a reserve of analysis and To cope with such ‘fast-burn’ crises, the authorities need expertise which can be drawn on during an actual crisis. to be prepared to take effective decisions quickly. The initiatives described in this section to produce MoUs Some crises are triggered by a steady accumulation of between the UK and EU authorities, and to create small shocks rather than some sudden event. For ‘Factbooks’ on financial firms, are designed to support example, in Japan a macroeconomic downturn in the this. early 1990s combined with equity and property price falls to erode gradually corporate creditworthiness and Official intervention to mitigate a crisis carries risks — collateral values. However, partly because banks did not both financial risks and the risk that private sector report non-performing loans or provisions against losses incentives to avoid future crises will be reduced. The until borrowers were close to default, the impact on understanding and experience developed through risk capital ratios and the financial system emerged only with assessment work can help the authorities to judge a lag. Although some small institutions failed earlier, the whether the gravity of the crisis justifies those risks. major banks did not experience serious difficulties until Ex-ante identification of vulnerabilities also helps target 1997. the authorities’ efforts to enhance their ‘toolkit’ of possible responses to crises. For example, one benefit of The gathering of market intelligence and risk assessment the reforms to the sterling money markets described in may allow such vulnerabilities to be detected at an early this section is that they have given many more UK banks stage. This can give time to help prevent a crisis. Even if direct access to central bank liquidity. Regular a crisis cannot be averted, early detection may give extra monitoring of potential shocks and vulnerabilities also time to prepare contingency plans and focus attention helps to design realistic tests of the procedures which on likely stress points. would be followed in a crisis, such as the planned test of responses to a pandemic flu outbreak. As discussed in Section 3, idiosyncratic or financial sector events may evolve more rapidly. The LTCM crisis Crises that slip under the risk assessment ‘radar’ can described in Box 7 is one example. Fraud — as, for never be ruled out. But having that ‘radar’ function, and instance, in the case of Barings — or other concealed the expertise to maintain it, can make those responses problems are also inherently unpredictable. Past better informed and so more effective. Section 4 Mitigating risks to the UK financial system 59

remains important to continue to develop practical arrangements to aid international co-ordination — for example, by identifying in advance the information that authorities could and should provide to each other in a crisis and by discussing in advance of any event the issues which complicate the resolution of crises spanning different jurisdictions.

…include improved information availability. Past UK financial crisis management exercises have underscored the importance of up-to-date information in guiding crisis responses. The FSA is leading a project — the ‘Factbooks initiative’ — to establish core information relevant to such responses for around 60 financial firms in the United Kingdom.(1) This includes proposals to draw together systematically important information already available to the authorities and also for the FSA to collect additional information from a subset of these firms both periodically and specifically during any crisis. The Factbooks will enable data on firms to be routinely shared between the UK authorities in a readily accessible way. Looking ahead, it will be important that these new processes involving the private sector are tested — for example, to confirm that data can indeed be transmitted to the authorities in a way that meets crisis management needs. An important component of Factbooks is firms’ contingency funding plans. Further work on the implications of a number of firms simultaneously invoking their plans, and on the assumptions underlying them, may be useful in identifying and reducing obstacles to effective liquidity management in a crisis. It may also inform more efficient responses by the authorities.

The UK authorities have assessed the resilience of the UK financial sector… Table 4.C Findings of the Resilience Benchmarking Project:(a) During 2005, the UK authorities conducted a survey of over recovery rates for critical business functions(b) 60 major UK-operating financial institutions and infrastructures to assess their contingency plans in the event of Recovery period(c) Normal daily values Normal daily volumes (2) (hours) (percentage of) (percentage of) operational disruption. The survey was intended to help benchmark resilience across the financial sector, including Wholesale payments Within 2 55 to 85 50 to 70 potential dependencies between firms, and thereby serve as a Within 4 70 to 90 55 to 75 guide to contingency planning by individual firms and by the Within 24 75 to 95 70 to 90 authorities. The UK authorities also conducted a market-wide Trade clearing Within 2 20 to 40 15 to 35 Within 4 55 to 75 55 to 75 test of business continuity arrangements in November 2005, Within 24 75 to 95 75 to 95 involving some 70 financial institutions and infrastructures.(3) Settlement Within 2 30 to 50 20 to 40 Within 4 45 to 65 40 to 60 Within 24 65 to 85 60 to 80 The conclusions from these exercises were broadly positive. Systems and supporting infrastructures surveyed were Source: FSA, Resilience Benchmarking Project Discussion Paper, December 2005. generally found to be robust. For those surveyed, the majority (a) Available at www.fsc.gov.uk/upload/public/Files/9/Web%20- %20Res%20Bench%20Report%2020051214.pdf. of business volumes were found to be recoverable within four (b) Responses to the question: ‘What percentage of normal values/volumes would be restored within x hours of the decision to invoke your recovery plan?’. hours of recovery plans being invoked following a major (c) Period after recovery plan invoked. operational disruption (Table 4.C), although the full effects of

(1) See www.fsa.gov.uk/pubs/other/factbooks_feedback.pdf. (2) See www.fsa.gov.uk/pages/Library/Communication/PR/2005/136.shtml. (3) See www.fsa.gov.uk/pages/About/Teams/Stability/exercise_2005.shtml. 60 Financial Stability Report July 2006

a widespread and catastrophic event could result in markets being affected for a longer period of time. The main lessons related to staff planning; the need for improved co-ordination between institutions in the face of system-wide stresses, including through joint tests; and the need for the key UK infrastructures (including CREST, CHAPS, LCH.Clearnet Ltd and SWIFT) to give clearer indications to the market of their recovery expectations. Co-ordination has been improved with the establishment of the Cross-Market Business Continuity Group, which would feed information from private sector firms to the authorities in a crisis and facilitate private sector decisions and workarounds to alleviate pressures on the system. Based on these findings, the UK authorities are producing a sound practices guide on business continuity for the financial sector later this year. A shorter version of the benchmarking survey is also planned later in the year for smaller and less complex firms in the UK financial sector.

…including to a flu pandemic outbreak… The FSA has also recently carried out a survey of some 30 major firms’ readiness to deal with a flu pandemic. This found that many major firms had done some preparatory work following World Health Organization and UK Department of Health guidelines, centred on risk assessment and the identification of critical functions. The testing of the UK financial sector’s response to a potential flu pandemic is clearly important and a tripartite market-wide test is planned for later this year to examine the reactions of both the private and official sector to such an event.

Table 4.D Summary assessment of the main wholesale UK …with the Bank focusing on the core payment payment systems against Core Principles(a) infrastructures. The Bank has particular responsibilities for overseeing the Partly observed Broadly observed United Kingdom’s systemically important payment systems,

Observed (b) including ensuring these systems are robust to operational and € Not applicable € other risks. The Bank’s most recent risk assessment of these CREST £ and CREST US$ LCH.Clearnet Ltd PPS CHAPS £ and systems is contained in the Payment Systems Oversight I: Legal basis II: Understanding financial risks Report 2005.(1) III: Management of financial risks IV: Prompt final settlement In general, the Bank believes the core UK payment V: Settlement in multilateral netting systems VI: Settlement asset infrastructures — and participants in those systems — are VII: Security and operational reliability robust and have contingency plans in place that broadly reflect VIII: Efficiency good market practice to deal with operational problems IX: Access criteria X: Governance (Table 4.D). Where these plans tend to be less robust, however, is in capturing responses to operational problems affecting the financial system as a whole. As discussed in Source: Payment Systems Oversight Report 2005, Bank of England. Section 3, given the dependency of many UK institutions and (a) The Core Principles for Systemically Important Payment Systems, designed by the Committee on Payment and Settlement Systems, provide a set of minimum standards for risk management in systemically infrastructures on SWIFT, such contingency plans should important payment systems. See www.bis.org/publ/cpss43.pdf for a description of the Core Principles. (b) The LCH.Clearnet Ltd Protected Payments System (PPS) enables settlement of obligations between extend to messaging services. LCH.Clearnet Ltd and its members in twelve currencies. The assessment shown above relates to the main three currencies settled, namely sterling, euro and US dollar. One exception to the assessment shown above is that the Bank continues to assess the UK PPS’s arrangements for US dollar settlement partly to observe Core Principle VI, and for the US PPS’s arrangements for US dollar settlement broadly to observe Core Effective plans to mitigate the impact of such system-wide Principle VI (see Annex C, Payment Systems Oversight Report 2005). events would need the following ingredients. First, a clear

(1) Available at www.bankofengland.co.uk/publications/psor/index.htm. Section 4 Mitigating risks to the UK financial system 61

understanding among market participants of infrastructures’ contingency plans and the business implications of those plans. Second, an understanding of what actions the public authorities might take, domestically and on a co-ordinated international basis, in response to an infrastructure problem. And third, plans within the private sector that are mutually compatible and tested.

While there has been some progress over the past six months, further work is needed, in particular on the second and third elements. On the first, many market infrastructures already provide some level of business continuity guidance to users; for example, SWIFT recently issued an update to its user handbook to add more detail on its contingency plans. Nonetheless, further work remains to be done in this area to ensure users have thought through the implications of this guidance. On the second, recent reforms to the sterling money markets would help in managing the liquidity consequences of an infrastructure problem in the United Kingdom. Internationally, however, there is a need for further work on co-ordination and information sharing between the authorities. Finally, it is in the area of private sector co-ordination that the need for greater planning and testing is greatest for system-wide disruptions, such as those associated with a disruption to market infrastructures or messaging services. The UK authorities have recently tested their own responses to such an event.

The Bank aims to help facilitate these mitigating actions and to help test them once in place. Longer term, there may be a case for UK financial firms and infrastructures to consider enhancing their backup arrangements with alternative standby suppliers of communication services, to reduce the risk of a single point of failure. 62 Financial Stability Report July 2006

Reform of the International Monetary Fund. Other financial stability Mervyn King, Governor, February 2006. publications www.bankofengland.co.uk/publications/speeches/2006/ speech267.pdf This section provides a short summary of other financial stability related publications released by the Bank of England In this speech, the Governor notes the vast changes that have since the December 2005 FSR. taken place in the international financial system since the establishment of the Bretton Woods institutions. In particular, Regular publications the dramatic growth in private capital flows has increased interconnections between national balance sheets and, as a The Payment Systems Oversight Report 2005. result, the extent to which policies in some countries can The Payment Systems Oversight Report provides an account of spillover to others. The Governor argues that in response the how the Bank is discharging its responsibility for oversight of IMF should look to focus its work on the international UK payment systems. The latest Report is available on the monetary system around three main tasks: to provide and Bank’s website at: share information about the balance sheets of all major www.bankofengland.co.uk/publications/psor/index.htm. countries and the links between them; to encourage countries to abide by their commitments to each other by promoting Markets and operations article, Bank of England Quarterly greater transparency about national policies; and to provide a Bulletin, Summer 2006. forum for national authorities to discuss risks to the world This article reviews developments since the Spring Quarterly economy. In pursuing these objectives, the Governor suggests Bulletin in sterling and global financial markets, in market that some reform of the Fund is required, including reducing structure and in the Bank’s balance sheet. The latest Quarterly the size of meetings to encourage the necessary degree of Bulletin is available on the Bank’s website at: frankness to tackle challenges facing the international financial www.bankofengland.co.uk/publications/quarterlybulletin/ system. qb0602.pdf. Uncertainty, the implementation of monetary policy, and Speeches the management of risk. Paul Tucker, Executive Director for Markets, May 2006. Remarks at a Chatham House Conference on Global Financial Imbalances. www.bankofengland.co.uk/publications/speeches/2006/ Rachel Lomax, Deputy Governor, January 2006. speech273.pdf www.bankofengland.co.uk/publications/speeches/2006/ Paul Tucker discusses the sources of volatility and uncertainty speech265.pdf facing firms and financial markets. In particular, the management of risks from pension fund asset-liability This speech discusses whether the current pattern of financial mismatches has been an important influence on financial imbalances between major economies presents a threat to markets in recent years. More generally, the compression in economic activity and financial stability, and whether the credit spreads and other market-based indicators of risk current international monetary system has sufficient suggest a fall in the price of risk. It remains unclear to what incentives to ensure an orderly unwinding of these imbalances. extent that has reflected structural change or other factors, The speech discusses different interpretations of global such as the search for yield. And even where structural change imbalances and identifies key features of the international has been the driver, market participants should be careful monetary system that are particularly relevant for financing, about extrapolating forward the high returns that might be containing and correcting imbalances. Rachel Lomax argues associated with a period of transition. One key area of that an open-ended commitment by Asian central banks to structural change within financial markets has been innovation finance ever increasing US deficits is implausible going in structured finance, which by distributing risk should buttress forward. In light of this, the speech argues that there is no financial stability as a whole. However, uncertainties about case for reintroducing Bretton Woods type constraints but the liquidity of and demand for structured products under instead policymakers need to manage risks within the current stressed conditions also has the potential to complicate the system. Policymakers must ensure excellent policy assessment and pricing of risk across financial markets. communication, to reduce uncertainty and limit the risk of sharp market corrections, and they also need to appreciate better the interdependencies between policy decisions in different countries. Other financial stability publications 63

Financial stability papers And most pension entitlements in these schemes remain defined benefit in nature. The shareholders of sponsoring Costs of sovereign default. companies are primarily responsible for ensuring Bianca de Paoli, Glenn Hoggarth and Victoria Saporta, pension-scheme solvency, and in the United Kingdom most July 2006. defined-benefit pension schemes are largely invested in equities. This provides scope for pension schemes to amplify www.bankofengland.co.uk/publications/fsr/fs_paper01.pdf shocks to companies’ stock market valuations. The paper uses a stylised model of a company’s market value to show how This paper assesses the type and size of costs that are shocks can be amplified through the additional leverage associated with sovereign default. In particular, it emphasises induced by pension liabilities and pension fund cross-holdings that output losses are particularly large when sovereign of equities. Econometric analysis of equity price volatility for a default is combined with widespread failure of the domestic sample of UK companies confirms that these effects are banking system and/or a currency crisis. Once in a debt crisis, significant. annual output losses seem to increase the longer that countries stay in arrears or take to restructure their debts. Switching costs in the market for personal current There is also evidence that output losses are smaller for accounts: some evidence for the United Kingdom. countries that restructure their debt than for those that do not. Céline Gondat-Larralde and Erlend Nier, March 2006. The paper concludes with a number of policy suggestions to improve debt crisis prevention and management and the role www.bankofengland.co.uk/publications/workingpapers/ played of the IMF. wp292.pdf

Working papers This paper provides an analysis of the competitive process in the market for personal current accounts in the United Modelling the cross-border use of collateral in payment Kingdom over the period 1996–2001. It finds only a gradual systems. change in the distribution of market shares over this period, in Mark J Manning and Matthew Willison, January 2006. contrast with a marked dispersion in the rates offered on retail deposits which appears to be persistent over time. The www.bankofengland.co.uk/publications/workingpapers/ analysis suggests that customer switching costs are likely to be wp286.pdf a key factor behind the low price elasticity of current account market shares over this period. These results are therefore Over the past decade there has been a marked shift towards broadly supportive of recent initiatives to facilitate switching real-time gross settlement of high-value payments in central between bank accounts in the United Kingdom. bank money. That has markedly reduced credit risk in the financial system, but has focused the attention of Resolving banking crises — an analysis of policy options. policymakers on the associated liquidity risks. This paper looks Misa Tanaka and Glenn Hoggarth, March 2006. at how a bank operating in multiple systems might face a mismatch between the location of the collateral holdings www.bankofengland.co.uk/publications/workingpapers/ required to back payments and its liquidity needs. The paper wp293.pdf uses a stylised model to demonstrate that the associated liquidity risks may be mitigated by allowing cross-border use This paper looks at policy options open to the authorities and of collateral. However, in some circumstances, the associated provides practical guidance to policymakers in resolving bank incentives to reduce total holdings of collateral could failures. It shows that, without regulatory intervention, weak potentially increase liquidity risk. banks have incentives to hold on to their non-performing loans and gamble on the recovery of these loans. Consequently, if Defined benefit company pensions and corporate the authorities cannot observe banks’ balance sheets, they valuations: simulation and empirical evidence from the may have to rely on financial incentives to induce failing banks United Kingdom. to liquidate bad debts. If the failing banks can be closed Kamakshya Trivedi and Garry Young, March 2006. without causing a systemic crisis, the ‘first-best’ policy is one where the authorities close all banks that are unable to raise a www.bankofengland.co.uk/publications/workingpapers/ minimum level of new capital. If closing the failing banks wp289.pdf could cause a systemic crisis, the second-best solution is for the authorities to inject equity into the banks. If that option is The majority of full-time employees in the United Kingdom are not used, it would be less costly to subsidise the liquidation of members of funded, company-sponsored pension schemes. non-performing loans than to inject subordinated debt. 64 Financial Stability Report July 2006

Index of charts and tables

Charts 2.5 Major UK banks’ dealing profits as a percentage of operating income 26 Overview 5 2.6 Major UK banks’ participation as lead arranger in global 1 UK banks’ write-offs remain low 8 syndicated lending 26 2 Ascent of asset prices 8 Box 3 3 Descent of risk spreads 8 A Major UK banks’ dealing profits as a multiple of 4 Return on common equity – high and rising 9 Value-at-Risk 27 5 Balance sheets expand rapidly 9 B LCFIs’ Value-at-Risk 27 6 Asset prices adjust 9 2.7 Major UK banks’ customer funding gap 28 7 Implied equity market volatility rises 10 2.8 Major UK banks’ maturity breakdown of wholesale 8 Major UK banks’ default premia remain low 11 funding 28 2.9 Major UK banks’ ‘large exposures’ to banks and LCFIs 1 Shocks to the UK financial system 14 by counterparty, end-March 2006 29 1.1 Real GDP growth forecasts, 2006 and 2007 14 2.10 Incidence of common ‘large exposure’ counterparts 1.2 Distribution of US GDP growth and inflation forecasts during 2006 Q1 29 for 2007 14 2.11 Major UK banks’ and LCFIs’ credit default swap 1.3 Official and forward interest rates 15 premia 29 1.4 Implied interest rate volatility 15 2.12 Major UK banks’ and LCFIs’ return on common 1.5 Real prices of oil and selected metals 15 equity 30 1.6 Speculative positions in gold futures 16 2.13 LCFIs’ revenue sources 30 1.7 Global current account balances 16 2.14 Major UK banks’ and LCFIs’ total assets 30 1.8 Ratio of assets to liabilities of UK debtor households, 2.15 LCFIs’ leverage 31 September 2005 17 2.16 Net capital flows into hedge funds 31 1.9 Annualised insolvency rates 17 Box 4 1.10 PNFCs’ annualised net equity issuance 17 A Gross and net leverage of US securities houses 32 1.11 Annual UK commercial property price inflation 18 B BIS indicators of hedge fund leverage 32 1.12 PNFCs’ capital gearing 18 2.17 Outstanding confirmations at large firms 34 1.13 LBO loan issuance 18 2.18 Traffic sent in SWIFT by location of sending 1.14 Market-implied US inflation expectations 19 entity 2005 34 1.15 Global real long-term interest rates 19 1.16 CDO tranche spreads and fees 19 3 Prospects for the UK financial system 36 Box 1 3.1 Major UK banks’ pre-tax return on equity 36 A International nominal forward rates 20 3.2 Major UK banks’ Tier 1 capital ratios 37 B Changes in nine-year forward rates 20 3.3 Bond spreads and equity indices 37 Box 2 3.4 Global current account balances 38 A CDO of ABS 21 3.5 Leveraged loan issuance 39 1.17 UK and international equity indices 22 3.6 Ratio of household sector debt to annualised 1.18 Implied equity market volatility 22 post-tax income 39 1.19 Common component in asset prices 22 3.7 LCFIs’ credit default swap premia 40 1.20 High-yield exchange rates 23 3.8 Major UK banks’ credit default swap premia 43 1.21 Daily changes in FTSE 100 23 3.9 Asset prices 43 Box 6 2 Structure of the UK financial system 24 A Risk transmission map 46 2.1 The major UK banks’ aggregate balance sheet as at B Impact and likelihood of ‘moderate stress scenarios’ end-2005 24 affecting vulnerabilities 48 2.2 Major UK banks’ annual write-off rates 25 C Impact and likelihood of ‘severe stress scenarios’ 2.3 Major UK banks’ annual growth in lending to UK affecting vulnerabilities 48 households 25 Box 7 2.4 Major UK banks’ annual growth in lending to UK A Risk transmission map: Russian default (August) and non-financial companies 26 LTCM near-failure (September 1998) 50 Index of charts and tables 65

4 Mitigating risks to the UK financial system 51 4.1 Access to the Bank’s facilities 53

Tables

Overview 5 A Risky asset prices rise then fall 10 B Some key vulnerabilities edge up 10

1 Shocks to the UK financial system 14 1.A Price changes of risky assets 23

3 Prospects for UK financial system 36 3.A Net assessment of news since the December 2005 FSR 37 Box 6 1 Summary of stress scenarios 45 2 Channels explicitly quantified in stress scenarios 46

4 Mitigating risks to the UK financial system 51 4.A Recent initiatives to improve financial sector risk management 51 4.B Existing cross-border collateral linkages 54 4.C Findings of the Resilience Benchmarking Project: recovery rates for critical business functions 59 4.D Summary assessment of the main wholesale UK payment systems against Core Principles 60 66 Financial Stability Report July 2006

Glossary and other information

Glossary of selected data and instruments IMF – International Monetary Fund. IMFC – International Monetary and Financial Committee. ABS – asset-backed security. IRB approach – internal ratings-based approach. CD – certificate of deposit. ISDA – International Swaps and Derivatives Association, Inc. CDO – collateralised debt obligation. LBO – leveraged buyout. CDS – credit default swap. LCFI – large complex financial institution. CPI – consumer prices index. LTCM – Long-Term Capital Management. CPPI – constant proportion portfolio insurance. LTV – loan to value. CRD – Cash Ratio Deposit. MBO – management buyout. Euribor – euro interbank offered rate. MoU – Memorandum of Understanding. FIN – one of SWIFT’s core messaging services. MPC – Monetary Policy Committee. GDP – gross domestic product. MSCI – Morgan Stanley Capital International Inc. Libor – London interbank offered rate. OMO – open market operations. MBS – mortgage-backed security. ONS – Office for National Statistics. RPI – retail prices index. OTC – over the counter. P&L – profit and loss. PNFC – private non-financial corporations. Abbreviations PPS – Protected Payments System. S&P – Standard and Poor’s. BIS – Bank for International Settlements. SEC – US Securities and Exchange Commission. CBI – Confederation of British Industry. SWIFT – Society for Worldwide Interbank Financial CHAPS – Clearing House Automated Payment System. Telecommunication. CLS – Continuous Linked Settlement. VaR – Value-at-Risk. CME – Chicago Mercantile Exchange. CRMPG – Counterparty Risk Management Policy Group. CPSS – Committee on Payment and Settlement Systems. DTI – Department of Trade and Industry. EME – emerging market economy. EU – European Union. FSA – Financial Services Authority. FSR – Financial Stability Review/Report. FTSE – Financial Times Stock Exchange. G3 – the euro area, Japan and the United States. G7 – Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. G10 – Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. GM – General Motors. HMT – Her Majesty’s Treasury. IFRS – International Financial Reporting Standards.

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